# INTEREST RATES. REAL INTEREST RATES Mishkin, P. 123-125.

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INTEREST RATES

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 on a Simple Loan 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.

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 P t, the foregone current goods are The goods value of the future repayment is

Real Interest Rate The real interest rate on the loan is defined as the future goods received relative to current goods foregone

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.

Ex Ante Rate and the Fisher Effect 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.

Great Inflation of the 1970’s Source: St. Louis Federal Reserve http://research.stlouisfed.org/fred2/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 Nominal Anchor Variable used to pin down the value of currency. Operating Instruments Tools Direct powers of the Central bank. 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 S D i IBR Reserve Accounts i*i*

Equilibrium Excess Supply: If i IBR > 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 i IBR < 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

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 AssetsLiabilities Monetary Liabilities Currency Reserves Non-monetary Liabilities Long-term “Stabilization Bonds Government Fiscal Reserves Government Bills Foreign Reserves Unconventional Assets

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 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. AssetsLiabilities +100 T-Bills+ 100 Reserves AssetsLiabilities +100 Reserves -100 T-Bills Fed Balance Sheet Bank A Balance Sheet OMO’s usually implemented with repo operations.

Repurchase Agreements: Repo 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 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

28 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 S D i IBR Reserve Accounts i*i* i LF i SF

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 i LF. 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 i DF.

POLICY RATE

Criterion for Operating Instruments 1. Controllable 2. Observable 3. Linked to Goals Operating Instruments are the Targets that central banks set in day to day operations.

33 Why short-term rates as policy instrument? 1. Controllable: Central bank controls liquidity conditions in certain market 2. Easily Observable: changes send clear signal of changes in policy 3. Helps to Achieve Goals A. Financial Stability: avoid fluctuating interest rates B. 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 FedFederal Funds Rate BoJUncollateralized Call Money Rate ECBMain Refinancing Rate BoKBase Rate UKOfficial Bank Rate

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 S D i IBR Reserve Accounts iPiP i LF i SF MRO

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. S D i IBR Reserve Accounts iPiP i LF i SF MRO i*i*

BoK Monetary Policy Report

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 S D i IBR Reserve Accounts iPiP i LF i SF MRO S´S´ iP´iP´ i SF ´ i LF ´ D´D´ 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 45 Principles

46 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 i IB < i MM, borrow in interbank market, lend in money market; if i IB > i MM, then reverse.

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

49 “..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 Link

50 Monetary Policy Transmission Mechanisms in Pacific Islands Countries

Open Market Operations Eligible Securities U.S. Fed only uses T-bills and T-bonds for repurchase ECB and BoJ use some private securities including collateralized bonds and high quality commercial paper.

Monetary Transmission Mechanism Interbank Interest Rate Money Market Rates Forex Rates Economy Stock Prices LT Interest Rates

53 Principles of Monetary Policy Strategy, Pt. III Managing the Future 4. Expectations are critical to monetary policy outcomes; Expectations are critical to monetary policy outcomes; 5. Taylor Principle is necessary for price stability Taylor Principle is necessary for price stability Expectations, Policy Credibility, and Transparency 53 Mishkin, Monetary Policy Strategy After the Crisis

4. Why are expectations so important? Economic decisions such as price-setting, hiring, wage contracting, investment are made only intermittently. Rational actors will take future conditions into account when making decisions, since they know they will live with them for a while. Ex. If workers think inflation will be high in the future, they will only sign contracts today that allow for high wage growth to maintain living standards. 54 Principles

TERM STRUCTURE Chapter 6: The Term Structure of Interest Rates

Term Structure of Interest Rates Bonds of different maturities typically have different interest rates. Typically, bonds of longer maturity pay higher yields over their lifetime. Segmented Market Theory: Long-term bonds have greater interest rate risk and less liquidity. This explains why long-term bonds have greater yields on average.

Average Yield Curve: Korea Yield Curve

Expectations Theory Portfolio holders are indifferent between long and short-term bonds. Yield to maturity over the life of a long-term bond must be equal to average yields on repeated rollovers of short-term bond holdings during the same period.

Consider two strategies which should have the same expected pay-off. Starting with \$1. 1. Buy a two year discount bond and hold it for two years. Payoff: 2. Buy a 1 year bond. After 1 year, invest pay-off in another 1 year bond. Payoff: Two Strategies

Arbitrage between markets implies equal returns on equal assets. Equal pay-offs imply that yield on a two year bond is equal to the expected average yield of 1 year bonds over the next two years.

In general, if the pay-off for investing in an n period bond should be the same as the pay-off from rolling over 1 year bonds for n periods: Then a n period bond yield is (approximately) equal to the average expected yield on 1 period bonds between today and date n.

Preferred Habitat Theory Bonds have some differences in risk and liquidity characteristics. Regardless, they are close substitutes and the expectation theory well describes the connection between bonds of different yields. Yields of bonds of period n are represented as the The maturity premium h n tends to increase in n.

Forecasting with the Term Structure If the expectations theory holds, long-term interest rates can be used to infer market expectations of future interest rates. Steep yield curve indicates low short-term rates and high future interest rates. Inverted yield curve indicates high short-term rates and low future interest rates.

Short Rates More Volatile than Long

Monetary Expansion Means Steep Yield Curve

What drives policy changes Nominal anchor and monetary policy framework determine necessary changes. In inflation targeting framework, central bank must announce inflation target and publish

67 Real interest rate impacts demand for goods. Real interest rate is r t = i t - E[π t+1 ] When E[π t+1 ] rises, central bank should increase i t more than 1-for-1 to raise real interest rate, limit demand and limit inflation. When E[π t+1 ] falls, central bank should reduce i t more than 1-for-1 to drop real interest rate, raise demand and avoid deflation. 5. Economics of the Policy Mechanism Taylor Principle

Zero Lower Bound One constraint on using the interbank interest rate as an operating target: nominal interest rates cannot go below zero. As inflation drops, the central bank can purchase government securities to lower interest rates only up to the lower bound. Once, that point has been reached banks will no longer lend out their excess reserves preferring to keep them rather than accept a negative interest rate. A bank that sets a ZIRP, zero interest rate policy must also target a level of reserves

Zero Lower Bound Taylor Principle suggests that when inflation expectations fall, the policy rate should be brought down on a more than 1-for-1 basis. But interest rates cannot be brought down below zero: no one will lend money with a negative interest rate since money always pays a 0% interest rate. 69

Japanese Monetary Policy 70

Six Strategies for Dealing w/ Zero Lower Bound (i) expanding the central bank’s balance sheet beyond level required (ii) targeted asset purchases: altering the central bank’s balance sheet to change the relative supplies of securities in the market (iii) managing interest-rate expectations : lower long- term rates; (iv) Increase inflation target (v) Price level target (vi) Negative Interest Rates 71

i. Expanding Balance Sheets In 2001, Bank of Japan implemented a sharp increase of OM purchases to expand bank reserves referred to as Quantitative Easing. Banks mostly held extra reserves on their balance sheets and did not increase lending or deposit creation. In 2013, Japan begins asset purchases again. 72

Japan: Quantitative Easing…2 rounds 73

USA: Quantitative Easing Challenges to Monetary Policy Effectiveness 74

ii. Targeted Asset Purchases B o J, "Quantitative and Qualitative Monetary Easing " 75 Bank of Japan announcement April 4, 2013 -- “An increase in JGB purchases and their maturity extension by a unanimous vote -- With a view to encouraging a further decline in interest rates across the yield curve, the Bank will purchase JGBs so that their amount outstanding will increase at an annual pace of about 50 trillion yen.” “In addition, JGBs with all maturities including 40-year bonds will be made eligible for purchase, and the average remaining maturity of the Bank's JGB purchases will be extended from slightly less than three years at present to about seven years…” LinkLink

LT interest rates fell 76

QE Large-Scale Asset Purchase Program 77

iii. Interest Rate Expectations Management Ueda (2005) argues that Japan QE was part of a strategy to indicate a BoJ commitment to pushing down long-term interest rates. In 2009 financial crisis, Bank of Canada was more explicit… 78 Did reversal of first QE reduce credibility?

79 …With monetary policy now operating at the effective lower bound for the overnight policy rate, it is appropriate to provide more explicit guidance than is usual regarding its future path so as to influence rates at longer maturities. Conditional on the outlook for inflation, the target overnight rate can be expected to remain at its current level until the end of the second quarter of 2010 in order to achieve the inflation target. …… Bank of Canada Website Bank of Canada Website

Fed offers FOMC forecasts of policy 81 BACK

iv. Raise Inflation Target Cost of borrowing (in terms of purchasing power) is the interest rate adjusted by the inflation rate between the time a loan is made and the time is repaid. 82 With zero interest rates, real borrowing rates will fall when inflation rises.

Inflation Target 83 The newly-introduced "price stability target" is the inflation rate that the Bank judges to be consistent with price stability on a sustainable basis. … Based on this recognition, the Bank sets the "price stability target" at 2 percent in terms of the year-on-year rate of change in the consumer price index (CPI) -- a main price index. Link

Interest Rate Management and Inflation Targeting Ben Bernanke (1999) – “In particular, a target in the 3-4% range for inflation, to be maintained for a number of years, would confirm not only that the BOJ is intent on moving safely away from a deflationary regime, but also that it intends to make up some of the “price-level gap” created by eight years of zero or negative inflation.” 84 Make-up inflation target sometimes referred to as price-level targeting

v. Price Level Targeting Level targeting is a backward looking form of inflation target in which central bank responsible for fixing past mistakes. If there is a large negative shock to inflation that drives interest rate to zero, central bank commits to raising future inflation. Challenges to Monetary Policy Effectiveness 85

Price Level Targeting vs. Inflation Targeting USA Challenges to Monetary Policy Effectiveness 86 Link

Price level would be 40% higher if previous trends had continued Challenges to Monetary Policy Effectiveness 87

vi. Negative Interest Rates Euro Deposit facility puts tax on deposits. Challenges to Monetary Policy Effectiveness 88

Negative Rates In a deflationary slump, banks hold large stocks of excess reserves rather than make loans. When interest rates are zero, this is costless. When interest rates are negative, taxes penalize this behavior, stimulating lending (hopefully). Challenges to Monetary Policy Effectiveness 89

Prevention: Making Liquidity Traps Less Likely Central banks have targeted inflation near 2% which has kept short-term interest rates low on average Running a higher inflation target might give more cushion to cut rates. 90