Money market operations and short-term interest rate volatility in the United Kingdom

This study examines whether in the United Kingdom the choice of the operational framework for monetary policy has been systematically related to patterns in money market rates. It first focuses on the Bank of England's policy target, the two-week repo rate. The tests indicate that tighter spreads between the two-week market rate and the official repo rate result in lower money market volatility at the very short end of the money market curve. The effects at the longer end are much weaker. But no evidence is found of transmission of two-week volatility along the money market curve. In contrast to many other central banks, the Bank of England does not employ an operating target for the overnight rate. No evidence is found that allowing greater variation in overnight rates undermines efforts of the central bank to keep market interest rates in alignment with its monetary policy target. The results further indicate that volatility of rates at the very short end of the UK money market yield curve has declined significantly since the early 1990s. The introduction of the gilt repo market in January 1996 was associated with lower money market volatility, although there is evidence that volatility had started to fall as early as mid-1995. The effects of the 1997 reforms of the Bank of England's open market operations are less discernible in the data. In contrast, the creation of a ceiling for overnight rates in June 1998 was more clearly associated with a reduction in volatility of end-of-day overnight rates.