Do Central Banks understand the market role of interest rate? or is it just another price control?

These days, interest rates are rising globally at a faster phase. The main reasons are inflation expectations connected with rising inflation, interest rate hikes by central banks and rising risks of economic and business activities.

The fine example is the present market turmoil in the UK from September 26 immediately after announcing the Govt. mini budget on September 23 with a historic tax cut of £45 bn and a cap on annual household energy bill at £2,500 reduced from £6,500 for the aim of promoting growth and controlling inflation. As immediate financial market response, the currency tumbled to historic low and govt. bond yields shot up in speculation of rising debt to finance the mini budget deficit and resulting inflation. Meanwhile, the pension fund industry being a major investor in bonds started confronting a bankruptcy-threatened liquidity risk due to plummeted bond prices. 

As a result, the Bank of England (BoE) had to announce £65 bn worth bond buying programme until October 14 and suspended its existing £90 bond selling programme of the monetary policy until October 31. This bond market intervention was as a measure announced to retore orderly market functioning for the safeguard of financial stability by avoiding a run-on pension fund industry. 

However, the BoE or any economist so far had not recognized this level of risk exposure of pension fund industry. Further, this BoE intervention is a major contradiction to the super tightened monetary policy presently pursued by the BoE aiming at controlling of 4-decades high inflationary pressures.

In response, the IMF blamed the government for using UK’s institutions for cross-purposes. However, the BoE intervention was purely an independent reaction to the market within the BoE’s remit, given the government’s autonomy to deliver the fiscal policy. Therefore, the UK’s Finance Minister on October 13 commented that the BoE would be to blame if the markets slide at the end of the bond buying programme as announced.

As central banks have only the interest rate instrument to achieve all of their objectives, i.e., financial stability, price stability, economic stability, or any other stability, what they do is the control of interest rates through their public powers on printing and creation of money in the economy. Therefore, the economic basis on which central banks differentiate their policy objectives from time to time is not clear when the economic impact of interest rates is considered.

Therefore, this article is intended to shed some light on how interest rates operate in economies and whether central banks have the information and knowhow to control or regulate interest rates towards their national economic objectives as stipulated in the respective statutes.

Interest rates as another market price

We know that any economy is an aggregate of markets whose prices are an outcome of demand and supply forces including the government policy interventions. While markets are differentiated between goods and services markets and factor markets (i.e., labor, capital, land and entrepreneurship), interest rate is conventionally known as the cost or price of capital used in production of goods and services. Accordingly, prices of goods and services are the sums of costs/prices of factors including inputs or raw materials used to produce respective goods and services.

In modern monetary economies, interest rates are generally referred to the cost of financial capital used in economic activities whereas capital in conventional economics is the machinery or real capital used in the production. Since machinery and production operations are funded by money raised from savings or borrowed, the underlying capital is the financial capital. However, there can be different forms of financial capital such as deposits, bonds, equities and derivatives with different terms for respective financial costs such as interest on bank credit, yields on bonds and dividends on equities.

In general, financial capital is the use of money as a liquid store of value and a medium of differed value/payment. Each financial capital instrument involves in a transfer of monetary value between two parties for an agreed duration with an additional payment from the transferee to the transferer for the value involved in. This payment is the interest which is a financial cost to the transferee and a financial return to the transferer. This value transfer is the credit or debt that drives modern monetary economies. 

Therefore, a large network of entities led by central banks and banks has emerged to operate the business of credit and credit services in the economy whereas this credit business constitutes the monetary or financial side of the economy.

What constitutes the interest rate?

In micro perspective of a credit transaction, the role of interest rate is different between the borrower and lender. Interest rate is the return or incentive to the lender to save money today and defer its spending to the future.  In contrast, it is the incentive to the borrower to  bring spending to the present from the future. Therefore, borrower has the opportunity to spend more than his present income.

However, as a credit transaction is a deferred value transaction, both undergo a value risk during the deferred or credit period. Therefore, it is necessary to assess whether the interest rate underlying the credit transaction is adequate to cover the underlying value risk. The risk is primarily whether a party becomes worse-off or loses the value at the end of the credit period. Therefore, the risk emanates from several sources.

• First is the is the risk of default to the lender with corresponding risk of liquidity to the borrower. Those two risks are the two sides of same coin. If the borrower is unable to generate an income and cash to repay the lender, which is liquidity risk, the lender confronts the resulting default risk.

• Second is the real value or inflation risk. As prices change during the credit period, the purchasing power of credit will change, accordingly. For example, if the inflation at the end of the credit period is higher than the current inflation, the lender loses his purchasing power of money involved in credit at the time he recovers it back from the borrower. Therefore, inflation is a real loss to the lender. In contrast, inflation offers a real benefit to the borrower by the opportunity of purchasing today at prices lowers than in future. Therefore, the borrower gains in real terms. He loses if there is deflation during the credit period.

• Third is the monetary policy risk. As the credit/financial system runs on money/credit printed by the central bank, the central bank interest rates or policy interest rates serve as the foundation for the interest rates in the rest of the economy. Therefore, changes in the policy interest rates during the credit period constitute an external risk to lenders and borrowers in both current credit transactions and future credit transactions as changes in policy interest rates cause changes in credit market conditions and expectations.

• Fourth is the US monetary policy risk. As the US dollar is the leading global reserve and invoicing currency, the US monetary policy transmission is a considerable risk to interest rates and credit conditions in all countries. Capital flows and changes in currency value/exchange rate against the US dollar are the major sources of risks. Therefore, monetary policy interest rates across the world in general are akin to the US interest rate cycles.

• Fifth is the interest rates on government securities and fiscal deficits. As credit to government is considered as the least default risk in the country as compared to all other classes of credit, government bond yields are considered as the risk-free interest benchmark to determine the interest rates on private credit transactions. Further, credit to government dominates the credit market in volume. Therefore, the yield curve that represents yield rates across various maturities, short, medium and long-term, of government securities is treated as the term structure of interest rates in determining and speculating of interest rates on credit transactions in the rest of the economy including the monetary policy-based credit. 

In general, the yield curve is a major consideration to determine the market interest rates as well as monetary policy interest rates. In most countries, central banks intervene in the yield curve at preferred points to drive the interest rates under the monetary policy. In some countries like Japan, monetary policy is largely yield curve based. Therefore, some yield rates serve as de facto policy interest rates.

This is why the bond market rates in the UK soared suddenly during the past two weeks consequent to the announcement of the mini budget and the BoE decided to intervene by purchasing long-dated bonds to calm down the markets. Sri Lankan yield curve flat around 30%-33% high shows not only the imminent risk of default of the domestic debt of the government due to debt servicing difficulties but also the destruction of private credit markets.

• Sixth is the current and expected economic growth, business environment and sentiments. It is common sense that supply of credit will be more, and interest rates will be lower in growing economies with promising business sentiments as risk to credit and businesses will be lower. The fine example in opposite is Sri Lanka confronting an economic crisis with negative growth of 8%-9%, default of government foreign debt, 30%-33% yields on government securities, almost zero foreign currency reserve and more than 80% currency rate depreciation.

Accordingly, attributes that constitute interest rates are the risks underlying the credit transactions. Therefore, interest rates represent the returns sought to undertake such risks. As the risks and risk assessment differ across the parties and classes of credit, a wide range of interest rates can be seen in the economy. A good example is the bank interest rates paid on deposits of same tenure and different tenures within banks and across banks.

As a rule of thumb in economies with active markets, it is accepted that the higher the risk, the higher is the return or interest rate in normal times. Therefore, a plausible query is whether current interest rates on Treasury bills around 30%-33% in Sri Lanka as compared to bank fixed deposit interest rates around 12%-20% reflect higher risks involved in lending to the government. As the risk assessment as well as risk-taking preference are largely a qualitative and speculative exercises, a person taking a higher risk stance by lending to government could be justified, given the status of government financial/Treasury management with default of foreign debt and depleting tax revenue.

Market Practice of Interest Rate Movements

Money is a resource employable to earn an income or return adequate to cover the underlying business risks inclusive of default/credit risk. This is the real return expected on investment of money. Various persons or investors will have own levels of real return based on the risk assessment. In addition, another risk premium will be added on to the real return to cover the real value risk from expected inflation prevailing beyond the control of the investor. Accordingly, an investor will charge a market interest rate equivalent to the real return plus inflation risk premium.

Therefore, market interest rates frequently adjust to changes in inflation expectations even if the business risk remains unchanged. However, movements in market interest rates are largely reflective of changes of both business risk and inflation risk that drive changes in market forces or credit demand and supply conditions. 

This shows that the ability of central banks to intervene in market interest rates is highly limited as they do not have a direct handle in controlling business and inflation risks in real time. Therefore, frequent movements of market interest rates in real time are a general feature in all economies around the world.

Interest rates to drive resource allocation and redistribution

In basic economics developed before modern monetary economies, it is the price mechanism that drives distribution of resources for production to solve basis economic problems confronted by societies. However, with the evolution of state money and monetary policy based monetary systems, interest rate has become the conduit between the production sector and monetary sector of the economy. This does not need any clarification as the transactions on production take place on valuation and exchange through money where monetary sector or money runs on credit.

Therefore, interest rate serves as the price mechanism not only for the distribution of productive resources between the present and future but also for the allocation of resources between the production sectors in the economy. Further, the development of global financial markets and reserve currencies, interest rate serves for cross-border allocation and movements of resources. As a result, a resource not mobilizable in the economy could be made productive through credit mobilized from overseas markets with global supply chains. The global economy and economic development of many countries exist today because of this internationalization of money and markets.

One noteworthy point is the role of bank deposit interest rates as the benchmark for driving investments to take risks that help innovation, busines promotions and economic development. As bank deposits are highly accredited for safety or low risks due to significant regulatory standards on prudence, people can think of the space to take higher risks alternative to deposits. 

Therefore, the lower the bank deposit interest rates structure, the wider the investment opportunities available for risk-taking and vice versa. For example, if bank deposit interest rates are raised from 6% to 18%, as in the case of present Sri Lanka, opportunities for business investment with returns in the range of 6% to 18% are lost and crowded out by bank deposits. This will have an adverse chain effect on the real economy. 

As such, keeping bank interest rates low or moderate for a longer period through the monetary policy is highly favourable to economic development with stability. This is why the maintenance of moderate long-term interest rates has been set as an objective of the US central bank.

Therefore, countries like Sri Lanka happening to struggle in currency crises and bankruptcy should find reasons from failures of their monetary systems for not being able to use interest rates and credit for the economic development.

Role of the monetary policy to drive interest rates

Interest rates are not purely competitive market outcomes as money and bank credit are highly controlled by central banks under the monetary policy and regulations. This means that the market of production of money and its prices or interest rates operate in a highly regulated environment. 

Therefore, the monetary side of the economy is largely controlled under the monetary policy to facilitate the production activities across the economy in terms of relevant legislations. As central banks have powers to print or produce money without any pre-determined limits, the monetary policy powers are considered to be huge. However, the issue is three-fold. 

• The first is whether central banks have the ability to intervene in interest rates to preferred levels because risks priced in interest rates are beyond the control of central banks. 

• The second is whether central banks have sufficient information on or pay enough attention to productive resources and flows of production sector-wise and economy-wide to drive the monetary policies in the interest of improving living standards.

• The third is whether their present monetary models are public friendly as set out in terms of relevant public legislations behind operations of central banks. For example, Sri Lankan central bank just changes its interest rates applicable to overnight deposits received from banks and overnight lending to banks against government securities from time to time for the objective of controlling inflation at an annual target of 4%-6% (known as inflation targeting monetary policy).

The lack of information and knowhow at the Sri Lankan central bank is revealed from many sources.

• First, the central bank Governor at the last monetary policy press conference held on 6^th October stated that the central bank does not consider sectoral developments such as SMEs or discuss with industrialists before making monetary policy decisions and, instead, it only assesses data on macroeconomic stability and inflation to make the policy decisions. 

• Second, he also commented at same conference that the interest cost in SMEs is small around 4%-5% or 7%-8% of cost of production and, therefore, present high interest rates-based monetary policy does not have a material impact on financial cost of the SME sector. However, he has entirely forgotten the need to repay the financial capital or credit involved in the production and is not certain about the level of financial cost. 

• Third, he has continuously maintained that the present level of inflation could be controlled only though a further contraction of the economy by the adoption of sufficiently tight monetary policy/high interest rates (now at 14.5% and15.5%).

• Fourth, the Monetary Board on 21 April 2022 issued an order to licensed banks requiring them to increase deposit interest rates adequately in line with the tight monetary policy measures adopted by the Central Bank to attract deposits into the banking system. This order had to be issued as banks were not prepared to raise deposit interest rates by such a higher rate (as compared to increase in policy rates by sudden 7%) because practical bankers know that it would kill the backbone of the intermediation business. The order is meaningless in three ways. First, it does not order banks what exactly should be done. Second, adjustment of market interest rates is a risk assessment-based decision (as pointed out above) which does not necessarily relates to policy interest rates. Third, attracting of deposits to the banking system does not go with the tight monetary policy measures as it would in fact raise credit creation ability of the banking system.

Accordingly, above four instances reflect just personal economic thoughts and models of the Governor and Monetary Board members which are non-compliant with the monetary policy provisions available in the Monetary Law Act that governs the Monetary Board and Central Bank of Sri Lanka. Therefore, central banks must act within the public powers authorized to them and not on attempts to implement their personal thoughts and models.

The brief presentation made above shows that the Monetary Board and Central Bank are required to regulate monetary sector through credit and interest rates to recover the economy from the present crisis as provided for in the Monetary Law Act. However, relevant authorities do not seem to have information and understanding in any of those. 

As a result, the economy, government and private sector continue to slip in further bankruptcy. The bankruptcy is a kind of financial position of erosion of assets and income causing inability to meet obligations on liabilities where such inability gets deteriorated daily if the underlying causes are arrested and resolved urgently. This is how businesses collapse in short times.

Accordingly, Sri Lankan economy is in a faster deteriorating path of the bankruptcy as no major fiscal and monetary policies have been taken during the past two years to arrest the situation as stipulated in the policy statues. Statutory violations by the policymakers are prevalent and continuing in Sri Lanka and have caused immense economic loss to the public on living standards without any counter action by relevant law enforcement authorities.

Further, competitive hikes of interest rates by central banks globally so far since the end of the last year for the purpose of taming the historically high inflationary pressures are driving the global economy into the willful recession before its fully recovery from the Corona pandemic in 2020-21.

(The next article will present how monetary policies are heading to destabilize economies with special reference to Sri Lanka.)

(This article is released in the interest of participating in the professional dialogue to find out solutions to present economic crisis confronted by the general public consequent to the global Corona pandemic, subsequent economic disruptions and shocks both local and global and policy failures.)

 

P Samarasiri

Former Deputy Governor, Central Bank of Sri Lanka

(Former Director of Bank Supervision, Assistant Governor, Secretary to the Monetary Board and Compliance Officer of the Central Bank, Former Chairman of the Sri Lanka Accounting and Auditing Standards Board and Credit Information Bureau, Former Chairman and Vice Chairman of the Institute of Bankers of Sri Lanka, Former Member of the Securities and Exchange Commission and Insurance Regulatory Commission and the Author of 10 Economics and Banking Books and a large number of articles published)