Monetary Transmission to UK Retail Mortgage Rates before and after August 2007

This paper investigates the transmission from UK policy and a range of wholesale money market rates to retail mortgage rates using the long-run estimator proposed by Phillips and Loretan (1991), with a single-equation error correction model (SEECM) framework, from 1995 to 2009. I document the economy-wide effect of the financial market turmoil since August 2007, and show how this has altered long- and short-term relationships. In the long-run there is evidence of a contrast between the discounted mortgage rates that banks may use to initially attract customers, and standard variable rates, with pass-through complete for the former but not for the latter. For fixed rate mortgages, pass-through is generally complete. Since the crisis, for eight of the seventeen estimated relationships I find strong evidence in the long-run of both a significant jump in equilibrium spreads, and a fall in pass-through, whilst in the short-run there is a considerable weakening of the process that re-adjusts retail rates back towards their equilibrium with the money market. Although I do not find strong statistical evidence for an asymmetric re-adjustment process before August 2007, retail mortgage rates generally take considerably longer to move back towards their equilibrium with wholesale rates during times when they are relatively expensive. These results add to previous studies by showing that the UK retail banking sector is imperfectly competitive at the aggregate level, and also suggest that discounted rates are used as a highly competitive loss-leader product.