2  BIS Review 71/2008  transmitted via financial markets to the real economy and to prices. 4 Monetary policy therefore strongly relies on well-functioning and liquid markets. The tensions in the money markets in recent months therefore posed a serious headache to most central banks. Not only did money market tensions indicate potential problems for financial stability, but it also threatened the smooth functioning of the transmission mechanism of monetary policy. The second important point concerning the transmission of monetary policy is the fact that it is not the current value of the policy rate that matters. Rather, it is the expected future path of that rate that determines the stance of monetary policy. For example, a central bank can have an impact on the economy simply by signalling that its own view about the future path of the monetary policy rate is different from the current market view. If the central bank is credible, market expectations will adjust correspondingly and financial prices will henceforth reflect the new view communicated by the central bank. 5 3. Chronology of the crisis  After these preliminaries, I will now turn briefly to the origins and the course of the financial market crisis, and in particular, the liquidity tensions brought about by the turmoil. The US housing market stands at the epicentre of the financial market crisis. After rising for several years, US house prices peaked in 2006.
Finally, by offering to borrow and lend overnight automatically, the Bank would relinquish day-to-day control over its balance sheet and the degree of risk associated with that. To summarise, there are different models for implementing the policy rate, each of which has its own merits and disadvantages. These reflect both monetary policy and financial stability considerations. A deeper exposition of the arguments can be found in Clews, Salmon and Weeken (2010).8 The Bank has carefully considered the differing systems and expects to return to a reserves averaging system in due course. Presumptively, that would be after increasing Bank Rate and before asset sales began – although the timing and sequencing will depend on the circumstances at the time. In the next section of this paper we explore more deeply some of the financial stability aspects of the Bank’s operations. The Sterling Monetary Framework: providing liquidity insurance Banks inherently engage in “maturity transformation” – borrowing on a short-term basis but lending on a long-term basis (eg taking deposits which can be withdrawn at short notice, and lending for mortgages). As a result, banks take liquidity risk – and even a well-run bank could suffer an unexpected shortage of liquidity. As part of their liquidity management, banks hold stocks of liquid assets that can be used to generate cash or make payments directly. Some assets are expected to retain their liquidity in all but the most extreme circumstances.