An Investigation into the Determinants of UK Interest Rates

This book employs three different methods for explaining and predicting UK interest rates.In the first chapter the change in the official interest rate is modeled as a qualitative dependent variable. The published Minutes of the Bank of England Monetary Policy Committee (MPC) are used to identify the explanatory variables included in the model and the probabilities from the estimated model are used to build a new measure of monetary policy shock which is added to a Vector Autoregression (VAR). This new measure of monetary policy shock is used to assess the impact of a UK policy shock on the sterling real effective exchange rate and on other macroeconomic variables.The second chapter makes use of high frequency asset market data to explain unexpected changes in interest rates using the methodology proposed by Cochrane and Piazzesi (2002). Our work departs from the existing literature because it uses UK market expectations to capture unexpected movements in the base rate, and explores its effect on a large number of asset market variables. Results indicate that the relation between asset market data and unexpected base rate changes is stronger and more consistent than the relation between asset market data and raw base rate changes.The third chapter avoids the limited information problem of the VAR approach used in chapter 1, by employing a Factor Augmented Vector Autoregression Model, similar to the one suggested by Bernanke, Boivin and Eliasz (Quarterly Journal of Economics, Vol. 120(2005), No.1, pp.387-422). This allows a large number of economic variables to be used in estimating the determinants of UK interest rates. Again the published Minutes of the MPC are used to identify the variables included in a large UK data set. Results indicate that this is a successful strategy with the out-of-sample performance for predicting interest rates of the factor-augmented model being clearly superior to that of the simple VAR and AR models.