Central Banks regulation and Interest Rates

Very often in financial media we hear people talking about Central Bank bringing Interest Rates higher or lower and the impact of these rates on the broad economy, mortgage rates, consumer loans etc. Let's look deeper into macro interest rates to better understand how do they affect our day to day life and the real economic sectors. Let's take a typical statement that we can come across reading through WSJ pages: "FED cuts rates by 0.25 point to reach record low of 0.50%". What does it mean? It may seem confusing as if tomorrow you would go to your local bank to apply for a mortgage your rates will be much higher. Let's try to understand what really happens and why this difference exists.

Government bonds

Bond Price vs Interest Rate

Governments to satisfy their budget needs as social security, defense, education etc. collect taxes and other state revenues which are usually not enough to cover all liabilities so they have to borrow money from investors. For that they issue Government Bonds with various maturities. In the United States they are called T-Bonds (Treasuries), in France - OAT, in Germany - Bunds etc. Bonds issued by highly rated countries are considered as an ultra-safe investment and their interest rates are close to risk-free rates. Government bonds are debt securities and are traded on the market. When any bond is traded it has a market price and interest rate. Both are linearly correlated, so when bond's price is going up the interest rate goes down. Therefore to bring the interest rate lower we need just start buying more bonds on the market increasing demand. To bring the rate lower we would obviously do the opposite it means sell bonds on the market. This is standard supply and demand rule. Remember well this relationship as it will be important later for understanding this article!

Commercial Banks

Walking down your city center you will certainly see several cash machines of well known local banks. Depending on the country you are living in examples can be City Group, Wells Fargo, Bank of America, HSBC, Barclays, BNP Paribas, Société Générale etc. All these banks are Commercial Banks operating in your country. Their traditional business is to finance individuals and corporations. To achieve this goal they are taking deposits from ones to give loans to others. Commercial bank lends money to an individual or corporation for a fixed or floating rate. In both cases this rate will be negotiated between the bank and its client within some interval of rates proposed by this concrete bank. Without going into details I'll just say that rate will be indirectly correlated to the current government bonds rate. It doesn't mean that it will be equal or close to this rate but when government bond rate increases the commercial bank's rates will increase too. I'll write an article explaining this relationship later.

Central Bank

Central Bank is a special type of bank that can be seen as a "bank of the banks". This definition may appear confusing as central bank's role goes far beyond of taking deposits and lending money out. Firstly central bank is an institution that manages a country's money supply, oversees the commercial banking system and acts as a lender of last resort to the commercial banks during financial crisis. As long as central bank possesses a monopoly of printing national currency its financing capacities are by definition unlimited. Thus the bankruptcy of the central bank is structurally impossible. In the most of developed countries the governments are controlling their central banks. The exception is United States where central bank (or Federal Reserve or FED) is a private company with a secret list of shareholders and the president of the bank is appointed by the president of the United States. In my opinion the word "bank" isn't applicable to the concept of the "central bank", as its primary role is regulation and not financing. Indeed it fulfills its financial role only in critical situations when regulation did not work properly.

Central Bank's regulation

As mentioned earlier one of the key roles of the central bank is to manage money supply. Money supply doesn't necessary mean "printing money" but more generally it refers to the amount of money available to the economy or amount of money available to the commercial banks financing this economy (individuals and corporations).

Typically central bank can increase money supply when GDP growth is slowing down, interest rates are too high, inflation is lower than its target level (creating a risk of deflation) or when currency rate is considered as unacceptable. On the other hand it can decrease money supply when there is a risk of a bubble on the real estate and/or capital market, interest rates are too low, inflation is far above its target level and/or again currency rates are considered unsatisfactory.

To regulate money supply central bank basically has 2 options:

1. Alter the reserve requirement.
2. Influence current interest rates on the market using OMO.

Reserve Requirement

Commercial banking system is very important and a bankruptcy of a significant commercial bank can have substantial consequences for the broad financial system. This is where central bank comes into play. To accomplish its regulatory role the central bank sets reserve requirement. Reserve requirement is an amount of capital that commercial banks have to put aside for each loan they are lending out. The required reserve ratio is sometimes used as a tool in monetary policy, influencing the country's money supply by changing the amount of funds available for commercial banks to make loans with.



Example:
Bank of America (BoA) lends out 100 000 USD and the reserve requirement set by the FED is of 10%, then 10 000 USD must be put to reserves and cannot be used for other loans. This amount can either be kept as cash or deposited to central bank.

Scenario 1: Increase reserve requirement to bring rates higher
FED brings reserve requirement to 20%. BoA would put 20 000$ aside for the same loan and this amount would "sleep" on the central bank's deposits producing a tiny interest rate. So BoA would have less money to lend out. As long as the reserve requirement affects all commercial banks then there will be less money available to the broad economy financed by these banks. When money supply decreases and the demand remain constant then, following supply and demand rule, the "price of money" will be higher. The "price of money" is Interest Rate. The objective of the central bank is achieved!
Scenario 2: Decrease reserve requirement to bring rates lower
FED brings reserve requirement to 5%. BoA would put only 5 000$ aside for the same loan. So BoA would have more money available to lend out. As consequence the broad economy would have more capital available too. When money supply increases and the demand remain constant then, following supply and demand rule, the "price of money" or Interest Rates will be lower. The objective of the central bank is achieved!

NOTE: Western central banks rarely alter the reserve requirements because it would cause immediate liquidity problems for banks with low excess reserves. They generally prefer to use Open Market Operations (buying and selling government-issued bonds) to implement their monetary policy (see below).

Open Market Operation (OMO)

Another option to alter money supply will be direct government bonds market intervention in order to technically affect the supply and demand. As mentioned earlier the rates paid on the government bonds indirectly affect loan rates proposed by commercial banks.

Scenario 1: Bring Interest Rates lower

Central bank will start buying government bonds on the market (probably with newly printed money if it wants to increase money in circulation) bringing the prices higher. As discussed earlier higher bond price means lower rate. The objective of the central bank is achieved!

Scenario 2: Bring Interest Rates higher

Just the opposite, central bank will start selling government bonds on the market bringing the prices lower and rates higher. The objective of the central bank is achieved!

CONCLUSION

Let's return to our original question what means the statement "FED cuts rates by 0.25 point to reach record low of 0.50%"? Usually the matter concerns target rate. Paradoxically this rate is the most often mentioned in the media but it is the less meaningful. Basically it refers to the rate to which the central bank will "push" short term government bonds on the market. We can also translate this statement that central bank is planning to increase money supply or inject liquidity.

Important to understand that such a statement doesn't mean that all commercial banks will now borrow money at central bank itself for a lower rate but that only means the intention of the central bank to push down interest rates proposed by commercial banks.