Tag Archives: Central Banks

Central Banks and Neutral Rates

Central Banks have often used the term ‘the neutral rate’ which refers to a rate of interest that neither stimulates the economy nor restrains economic growth. This rate is often defined as the rate which is consistent with full employment, trend growth, and stable prices – an economy where neither expansionary nor contractionary measures need to be implemented.

In most economies post GFC the neutral rate of interest fell as they have required lower rates to try and encourage growth. See table below of current rates of Central Banks and approximate neutral rates.

CB Interest Rate Nov 13

What indicators shoud you look at as to whether neutral interest rates might have changed? Here are 4 that are identified by John McDermott, Assistant Governor of the Reserve Bank of New Zealand:

1. World Conditions

Gowth of the major trading partners of any country can put pressure on aggregate demand which consequently causes inflationary conditions. With this and inflatinary expectations there could be pressure on a central bank to increase interest rates

2. Domestic productivity growth

A continued decrease in productivity growth will lower returns to investment, whcih means that investment is less attractive. If the desire to invest falls and the desire to save remains unchanged, a lower neutral interest rate will be required reconcile savings and investment plans.

3. Population growth

Lower population growth decreases the number of people in the labour force, meaning less investment is needed to provide the necessary capital stock to employ the average labour force. As investment falls, a lower neutral interest rate – the one that equalises the supply of and demand for funds – will be required.

4. Preferences for savings and investment

If people decide to save more and consume less a lower interest rate would be required to boost the pace of activity and inflation and reconcile saving and investment plans.

An implication of a lower neutral interest rate is that households and businesses will face lower interest rates ‘on average’, but this should not be read as a promise of lower interest rates all the time. Interest rates will need to be adjusted in response to the state of the economy. For times when demand in the economy is expanding more rapidly than the economy’s ability to meet that demand interest rates will need to be above neutral. Moreover, there is no reason to suppose how far interest rates move from trough to peak will be any different in the next business cycle than they moved in previous cycles. John McDermott, Assistant Governor of the Reserve Bank of New Zealand

Global Interest Rates

Many thanks to Yr 13 student Alex Rasmussen for this image. Most recently the Reserve Bank of Australia lowered its cash rate by 25 basis points to 2.5 percent. It was the second time this year that the Australian Reserve Bank has reduced its cash rate. The Bank believes that economic growth in Australia will remain below trend in the near term, “…as the economy adjusts to lower levels of mining investment”. United States Federal Reserve Chairman Ben Bernanke said in his Semiannual Monetary Policy Report to the Congress in mid-July, that “…a highly accommodative monetary policy will remain appropriate in the foreseeable future”.

Global Interest rates

The US Fed needs to be aware of its actions

With current central bank interest rates at very low levels there is concern that these policies have been fueling credit and asset price booms in some emerging economies. However, potentially there could be significant fallout of the unwinding of these booms on developed nations.

How do Capital Flows impact on an economy?
When you have long periods of loose monetary policy (including low interest rates), like that in the US 0-0.25% – since September 11 2001 the US Federal Reserve has implemented a near zero rate policy which is now expected to last until 2014. According to Stanford University Professor John Taylor this results in the following:

1 Investors look elsewhere to gain higher returns and buy foreign securities and
2 Low interest rates encourage overseas firms to borrow in US dollars rather than in their domestic currency – US branch offices of foreign banks raised over $645 billion to make loans in overseas countries.

This flow of money means that the strength of the local currency starts to appreciate as foreign firms exchange their borrowed US$ and for the domestic currency. With this appreciation, the central bank becomes concerned with the affect the higher currency is having on the exchange rate and therefore export competitiveness.

Central Bank Rates

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The above is a brief extract from an article published in this month’s econoMAX – click below to subscribe to econoMAX the online magazine of Tutor2u. Each month there are 8 articles of around 600 words on current economic issues.

econoMAX

WSJ Graphic – Central Bank Interest Rates

If you are teaching monetary policy in any course the graphic below shows a significant expansionary monetary policy. Remember in New Zealand the RBNZ changes interest rates to influence the level of economic activity in order to achieve price stability. Note the following:

• Implementation of monetary policy is one of the roles of the RBNZ
• The Reserve Bank Act established “price stability” as the main objective of the RBNZ. The RBNZ is therefore responsible for achieving “price stability”
• “Price stability” is defined in the PTA (Policy Target Agreement) as keeping inflation between 1 to 3% (measured by the percentage change in CPI)

In order to stimulate the economy the ECB cut benchmark interest rates to 0.75%. Chinese authorities cut one year yuan lending rate to 6% (still has ammunition left). The Bank of England reduced rates to 0.5%. This is in the hope that businesses will use the cheaper sources of credit to invest in their business and therefore create jobs. Lower rates would also ease the burden of those on floating interest rates.

Updated figures on NZ economy – useful for AS & A2 essay questions

When examiners mark essays they always like you to mention the current state of economic indicators in your economy. Below are the figures for the NZ economy as of 7th November from the Parliamentary Library.

Below shows the key rates of the the world’s central banks.

QE or QT

I have blogged quite a lot on QE – Quantitative Easing – which has been extremely prevalent in the developed world. However, what about QT – Quantitative Tightening? Remember:

QE – putting more money in the circular flow to stimulate demand
QT – taking money out of the circular flow to slow down the economy

According to the Business Insider website the developing world are trying to slowdown their economies. Here are some approaches from central banks:

China
The Chinese strategy is the most well known, as the PBOC has been trying to slow down credit growth through a series of bank reserve requirement ratio (RRR) hikes. Therefore if the RRR rate goes up it means that the bank has to hold more cash in reserve and has less to lend out.

Brazil
They have increased their IOF tax – the IOF tax applies upon conversion of foreign currency into Brazilian reals related to equity or debt investments by foreign investors on the Brazilian stock exchange. This dampens the Carry Trade and means less speculative money is put into the Brazilian Real. They have also increased the reserve requirement in banks to reduce liquidity in money markets to slow economic activity in the market.

Carry Trade – a situation where an investor borrows money in one country that has very low interest rates and then invests it in another country with higher interest rates. This can be precariuous as exchange rates vary.

Turkey
Here interest rates and reserve ratio requirements have actually gone in different directions.
Reserve requirements have climbed 8% for deposits maturing up to three months. These changes affect institutions with a local presence in Turkey. In order to sharply reduce the incentives for foreign players sending portfolio flows into Turkey, the policy rate was cut by 0.75% in conjunction with reserve requirement hikes in order to weaken the currency. The signaling aspect of such a cut has clearly played a strong role in driving market perception because investors tend to see Turkey’s monetary policy as expansionary. However, the net result of QT and policy rate cuts has likely been to make Turkish monetary policy tighter, not looser.

A new global reserve currency?

Dominque Straus-Kahn, the managing director of the IMF, has signaled the recommendation of a new global currency. Member countries hold with the IMF reserves that are referred to as Special Drawing Rights (SDR). His intention is the SDR could act as an alternative to the US$ in central banks’ foreign currency reserves.

The SDR is an international reserve asset, created by the IMF in 1969 to supplement its member countries’ official reserves. Its value is based on a basket of four key international currencies, and SDRs can be exchanged for freely usable currencies. With a general SDR allocation that took effect on August 28 and a special allocation on September 9, 2009, the amount of SDRs increased from SDR 21.4 billion to SDR 204 billion (equivalent to about $308 billion, converted using the rate of August 31, 2010). SDR’s are based on a basket of currencies – US$, £, €, ¥ – and should be broadened to include the Chinese Yuan.

Using the SDR would act as a safeguard from exchange rate volatility while issuing SDR-denominated bonds could create a potentially new class of reserve assets.

International policy makers have become increasingly concerned about the threat of currency wars. This is where governments have been trying to reduce the value of their currency to increase the competitiveness of their exports and claw its way out of recession.

Further tightening in the UK

Bank of England Governor, Mervyn King, has warned households to prepare for further increases in interest rates as inflation creeps higher. Mervyn King’s comments came after the Bank published its February Inflation Report, in which it lowered its forecast for economic growth this year from 2.6% to around 2% and confirmed that inflation could reach 5% before June – the UK has a target rate of 2% for the Consumer Price Index.

Currently the UK Bank Rate (equivalent to OCR in NZ) is at 0.5% but is expected to rise to 0.75% in the next four months and be at 1% by the end of the year. Projections for 2012 is 2% and by the end of 2013 the rate will be at 3%. Mervyn King also acknowledged that an 0.25% increase in the Bank Rate would not damage growth. “There’s one camp that says even a small rise in Bank rate, no matter how small, will plunge us back into recession and mean that hopes of recovery are dashed forever. I don’t really understand the logic behind that,” he said.

Compared to Australia and New Zealand rates in the UK, and US for that matter, are still very stimulatory – see table above. Interesting to note that the economies with higher interest rates are those that are more commodity based. It would be a useful exercise to draw a business cycle graph and look at the relationship between each country’s key interest rate and where they are on the business cycle.