Monetary policy and volatility in the sterling money market

Money market volatility may disrupt the transmission mechanism of monetary policy as well as increase uncertainty for market participants. This paper assesses the impact of reforms to the Bank of England’s operating framework over the last two decades. These reforms have been successful in reducing overnight volatility. A new framework in 2006 which introduced reserves averaging and voluntary reserve targets was associated with lower volatility of overnight rates. Further reductions in volatility were associated with interim reforms and communications prior to the launch of this new framework. The injection of excess reserves under the floor system introduced in 2009 has been associated with a further reduction in volatility. Despite these encouraging findings, further analysis shows that the volatility of overnight rates had little effect on the volatility of longer-term rates except in the pre-2006 ‘zero reserves’ period and no effect at all on three-month Libor rates, which are the key benchmark for many derivatives and bank loans. Since longer-term rates are more important than overnight rates for the transmission of monetary policy to the real economy, the results provide limited support for prioritising the reduction of volatility in the design of central banks’ operating frameworks. The results also suggest that additional communication regarding likely future monetary policy decisions is associated with lower volatility of term rates.