Real Interest Rates Mishkin, P. 123-125
Nominal and Real Interest Rates • Nominal return represents how much money you will receive after 1 year for giving up 1 dollar of money today • Real return represents how many goods you can buy if you give up the opportunity to buy 1 good today. • Nominal interest rate is money interest rate. Real interest rate is goods interest rate.
Interest rates are always measured in annual terms. Set T = # of years of a loan (may be fraction) A simple loan implies a loan of principal and a single repayment which is the principal plus interest. Interest on a Simple Loan
Imagine a 1 year loan [T =1]: The lender gives up some goods to make a loan and will buy goods in the future with the repayment. If the price of goods at time t is Pt, the foregone current goods are The goods value of the future repayment is
The real interest rate on the loan is defined as the future goods received relative to current goods foregone Real Interest Rate
Importance of the Real Interest Rate • Real interest rate is the intertemporal price of purchasing power. • If you buy 1 unit of purchasing power today, you give up 1+r units of future purchasing power. • It is the direct cost of credit for borrowers. • An important determinant of the intertemporal allocation of demand.
Savings and investment decisions must be made before future inflation is known so they must be made on the basis of an ex ante (predicted) real interest rate. Fisher Hypothesis: Ex ante real interest rate is determined by forces in the financial market. Money interest rate is just the real ex ante rate plus the market’s consensus forecast of inflation. Ex Ante Rate and the Fisher Effect
Great Inflation of the 1970’s Source: St. Louis Federal Reserve http://research.stlouisfed.org/fred2/
We can also examine the ex post real return on a loan as the money interest rate less the actual outcome for inflation. The gap between actual and forecast inflation determines the gap between the ex post (actual) and ex ante (forecast) return. Ex Ante vs. Ex post
Unexpected Inflation Winners and Losers • Higher than expected inflation means ex post real rates are lower than ex ante. Borrowers are winners/lenders are losers. • Lower than expected inflation means ex post real rates are higher than ex ante. Lenders are losers/borrowers are winners.
Identifying the Ex Ante Rate • Calculating the ex post rate is straight-forward using economic data. • Calculating the ex ante rate is harder since markets expected inflation is not directly observable. • Option 1: Use survey data to elicit beliefs about inflation. • Surveys of professional forecasters or perhaps consumers or corporate executives (better for short-term). • Option 2: Use yields on inflation protected securities. • Many large countries treasuries issue bonds that guarantee a pay-off in terms of purchasing power. The purchasing power yield that the market is will to accept should be similar to real yield on other assets (usually better for long-term).
Banknotes do not pay interest. The real interest rate on banknotes is If inflation is high, currency has sharply negative returns. People will avoid holding money leading to society losing the convenience of money transactions. The Inflation Tax
Structure of Monetary Policy Implementation Tools Direct powers of the Central bank. Operating Instruments Nominal Anchor Variable used to pin down the value of currency. Policy Feedback
Policy/Operating Instruments • “A variable that is very responsive to the central bank’s tools and indicates the stance of monetary policy” • Developed economies and emerging markets typically choose between using a short-term interest rate or an exchange rate as the instrument. • Determines the implementation of monetary policy.
Chapter 16 Interest Rate as the Policy Instrument
Interbank Market • In conducting payments, banks may face a shortfall of reserves and be forced to borrow reserves from other banks or the central bank at the interbank rate. • Demand: Each bank would like to keep a certain amount on reserve at any time to meet their own liquidity needs. Tradeoff for keeping stock of reserves is you cannot lend them to others. If the interbank rate IBR is high, they will want to lend their own balances to other banks and hold small reserves in their own account. • Supply: Central bank controls the supply reserves.
Interbank Market: Basics iIBR S i* D Reserve Accounts
Equilibrium • Excess Supply: If iIBR> i* , banks will have funds in reserve accounts in excess of that required to meet their own liquidity needs. They will offer funds at competitive rates pushing rates down. • Excess Demand: If iIBR < i*, banks will tend to hold on to reserves rather than lend them at unattractive rates. Banks facing shortfalls must offer better rates
Policy Instrument: Target for interbank lending rate • US Fed: Fed Funds Rate; • Bank of Japan: Uncollateralized Call Money Rate
Interbank Rate Link
Tools: Open Market Operations • Open Market Purchase: Central bank buys short-term government bills from commercial banks. Credits counter-parties with additional funds in reserve accounts. • Open Market Sale: Central bank sells bills to commercial banks. Debits counterparties reserve accounts. Sets supply of reserves
Central Bank Balance Sheets Assets Liabilities • Government Bills • Foreign Reserves • Unconventional Assets • Monetary Liabilities • Currency • Reserves • Non-monetary Liabilities • Long-term “Stabilization Bonds • Government Fiscal Reserves
T-Accounts • T-Accounts are a handy tool for examining the effects that any transaction has on balance sheets. • A bank transaction will change both liabilities and assets (and possibly net worth). The total change in liabilities plus net worth must always equal the total change in assets.
Open Market Purchase:Central Bank Purchases $100 of T-Bills from Bank A Fed Balance Sheet • Fed credits the reserve accounts of Bank A which increases its liabilities and takes possession of an equal value of securities as assets. • Bank A gets an extra amount of reserves and loses an equal amount of securities. Bank A Balance Sheet OMO’s usually implemented with repo operations.
Repurchase Agreements: Repo Reverse Repo Central bank sells quantity of government securities to commercial bank. Central bank simultaneously contracts to buy securities from the bank at some future date (typically 1 to 13 days) at a slightly higher price. Equivalent to perfectly collateralized deposit with interest • Central bank purchases quantity of government securities from commercial bank. • Central bank simultaneously contracts to sell securities back to the bank at some future date (typically 1 to 13 days) at a slightly higher price. • Equivalent to perfectly collateralized loan with interest
Tools: Standing Facilities • Loan Facility: Commercial banks can borrow reserves overnight at a loan facility rate. • Deposit Facility: Commercial banks can deposit reserves overnight at a deposit facility rate. These opportunities keep interbank rate within narrow band of the policy rate. For historical reasons, standing facilities are called the discount window.
Interbank Market: Basics iIBR S iLF i* D iSF Reserve Accounts
Facility: Supply and Demand • If the interbank rate rises above the lending facility rate, then banks can borrow as much as they want from the central bank through the discount window. Supply becomes perfectly elastic at iLF. • If the interbank rate rises above the deposit facility rate, banks can lend as much to the central bank as they want through the window. Demand for reserves is perfectly elastic at iDF.
Criterion for Operating Instruments • Controllable • Observable • Linked to Goals Operating Instruments are the Targets that central banks set in day to day operations.
Why short-term rates as policy instrument? Controllable: Central bank controls liquidity conditions in certain market Easily Observable: changes send clear signal of changes in policy Helps to Achieve Goals Financial Stability: avoid fluctuating interest rates Predictable Effects: transmission mechanism from changes in interest rate to economy are relatively well understood Back
Operating Instruments: Target Interest Rates • In this chapter, we examine the monetary policy of banks that use asset transactions to control the level of an interest rate in interbank market
Policy Rate Implementation • Monetary policy committee announces policy rate. • At regular intervals, central bank holds a reverse auction, offering to “lend”* banks as much reserves as they want to hold at policy rate. • Ex. Bank of Korea has weekly auction with 7 day rp agreements • Banks take up enough to fill demand. • By setting an interest rate, supply of reserves respond to demand. * Implemented by Reverse Auction
Main Refinancing Operation iIBR S iLF iP D iSF MRO Reserve Accounts
Fine tuning operations • On a day-to-day, minute-to-minute basis the willingness of banks to hold reserves will change creating intra-refinancing period volatility in the market interbank rate for reserves. • Standing facility creates a corridor for fluctuations in the interbank rate but this is only a backstop. Ex. Bank of Korea • Lending facility is policy rate +100 bps • Deposit facility is policy rate -100bs. • Central bank conducts ad hoc OMSs to match fluctuations in demand for reserves with supply in order to stabilize interbank rate (ex. BoK stabilizes overnight call money rate) near policy rate.
Increase in Demand for Reserves matched by fine tuning OMO purchase to keep interbank rate from rising. iIBR S iLF i* iP D iSF MRO Reserve Accounts
Operating Instrument in Euroland • The Governing Council (Monetary Policy committee) decides a rate of interest for these repos, the main financing rate, as the policy interest rate. • Every week, the ECB engages in 1-week repurchase agreements with banks in member countries at policy rate providing reserves in exchange for securities. • Auctions are decentralized and done through • In between periods, The ECB intermittently conducts fine-tuning operations to make sure , the interbank interest rate called EURIBOR, stays near the target.
Operating Instrument • In USA & Japan, all OMO’s are ad hoc. • No main refinancing operation.
What shifts the demand for reserves? • Demand for Broad Money – When households want to hold liquid assets, they hold liquid bank deposits. When bank deposits go up, demand for bank reserves go up. • Reserve Requirements – When regulations require banks to hold a high share of reserves relative to deposits, demand for reserves goes up. • Liquidity Risk – When the financial institutions want to hold liquidity, demand for liquidity goes up.
Changing the Target • After a decision has been made to change the target, the central bank’s traders kick into action and conduct active open market operations. • To lower the target interest rate, the central bank will conduct open market purchases, making reserves more plentiful and reducing the cost of borrowing them. • To raise the target interest rate, the central bank will conduct open market sales, making reserves less plentiful and raising the cost of borrowing them.
Cutting Policy Rates: OM Purchase iIBR S iLF S´ iLF´ iP iP´ D iSF D´ iSF´ Reserve Accounts MRO MRO´
Key point • Monetary policy decisions focus on expected future inflation. • Inflation expectations drive the real interest rate given choice of the policy instrument, so the policy instrument must respond to expectations. • Policy changes affect the economy only with a lag, so only helpful in responding to future inflation threats Principles
Interbank Rates and the Money Market • Money market: Debt markets w/ maturity less than 1 year: CP, T-bills, NCDs, repos. • Interbank rates steer rates in the broader money market through arbitrage. • If iIB < iMM, borrow in interbank market, lend in money market; • if iIB > iMM, thenreverse.
Money Market • Market for debt instruments with initial maturity less than 1 year • Treasury Bills • Commercial Paper: Corporate debt • NCD’s
Korean Money Market Source: CEIC Database
“..the pass-through from the overnight policy rate (OPR) to other interbank rates and retail market rates has remained high since April 2004 and has increased significantly during the most recent increases in the OPR … As the level of competitiveness in the banking system has increased over the past decade, long-run interest rate pass-through has also increased and has generally remained high,”Ooi Sang Kuang, Deputy Governor, Bank Negara Malaysia Link