## wpiea2020026-print-pdf ## Source details **Canonical URL:** [wpiea2020026-print-pdf](https://www.imf.org/-/media/files/publications/wp/2020/english/wpiea2020026-print-pdf.pdf) ## Other formats - [Markdown version](/-/media/files/publications/wp/2020/english/wpiea2020026-print-pdf.pdf.md) - [Structured JSON version](/-/media/files/publications/wp/2020/english/wpiea2020026-print-pdf.pdf.json) --- ### Key findings on operational frameworks and liquidity management - Shortcomings in operational frameworks and weak liquidity management are major obstacles for effective monetary policy implementation in many low- and lower-middle income countries (LLMICs). - Daily variation in overnight interbank rates is large in many LLMICs, in stark contrast to in advanced countries (Figure 1 and Appendix I). - Interbank rates have not been aligned with the policy rate in many LLMICs that use a policy rate to signal the policy stance; the spread has been at times both large and semi-persistent, with periodic large shifts. - For some countries, the difference between the policy rate and interbank rates is so large and the relationship so weak that the policy rate may have had little effect on commercial banks’ liquidity management and pricing decisions. - Consequences of misaligned or volatile short-term rates include: - High short-term liquidity risk. - Dilution of policy signals and weak monetary policy transmission. - Difficulty building central bank credibility. - Potential weakening of bank competition by creating arbitrage opportunities that favor larger banks with analytical capacity. ### Three critical issues for reforming monetary policy frameworks in LLMICs - How to choose an operating target for central banks’ daily liquidity management where: - monetary aggregates traditionally guide and implement monetary policy; and - financial markets are underdeveloped and the policy transmission and the direct interest rate channel are weak. - How to combine a continued role for monetary targets with an operational framework that ensures more stable and predictable short-term interest rates. - How to configure an interest-rate-focused operational framework in LLMICs, considering dependence on: - the policy framework; - the degree of market development; - the central bank’s liquidity forecasting capacity; - how the configuration may hamper or foster the development of security markets. ### Operational framework taxonomy and roles - A fully specified monetary policy framework comprises: - The primary objective of monetary policy (typically price stability). - The policy strategy and policy formulation framework (helps set the level of the operating target; intermediate targets for a monetary aggregate help map policy objectives to operations under a MT policy strategy). - The operational framework (operating target and monetary instruments the central bank uses to manage excess reserves and the interbank market conditions necessary to achieve the operating target). - Main operational tools: standing lending and deposit facilities (commercial banks can freely access at their discretion) and open market operations (OMOs). - Definition: “Excess reserves” are all liquid balances commercial banks have on their various reserve, overnight, and current accounts at the central bank in excess of required reserves, irrespective of whether all of these funds count against the reserve requirement; it excludes term deposits. ### Central thesis on the choice of operating target - Short-term interest rates should in most cases be the operating target for day-to-day monetary policy operations, even in countries that rely on a money-targeting policy strategy. - Two main reasons: - Monetary policy operations mainly work through their impact on market interest rates and yields, liquidity risk and risk premiums, the exchange rate, and expectations (Figure 3 and Appendix III). - Policy transmission to rates that influence private sector behavior—rates on longer-term securities, deposit, and lending rates—should be stronger when monetary operations ensure stable and predictable short-term rates. ### Requirements for effective policy transmission - Policy operations need to ensure: - Consistency between policy signals and actions. - That banks can predictably place surplus liquidity with, and obtain short-term funding from, each other or the central bank at rates that are reasonably stable and predictable. - Clear policy signals must be both credible and relevant; relevance requires that banks can obtain or place funds at the signaled short-term rate. - Large spreads between the policy rate and short-term market rates imply the policy rate is neither a credible nor a relevant signal and may weaken transmission. - Highly volatile short-term rates are hard to predict and impede financial market development. ### Role of OMOs and standing facilities in setting short-term rates - Central bank control over short-term interbank rates derives from: - Control over the total stock of reserve balances (commercial bank deposits at the central bank). - The terms for borrowing or depositing such funds with it (standing lending and deposit facilities). - Banks face daily payments resulting in a risk of ending the day short or long of reserves; those short must access the central bank’s standing lending facility (if available) to avoid failing interbank payments or reserve requirements. - OMOs influence the risk of the market ending the day short or long; the terms of the standing facilities (and penalties) determine the cost. The market or “shadow” price on reserves and the risk of being short or long determine overnight interbank rates when markets function; when markets are poorly functioning, a shadow price on reserves emerges (Appendix II). - Central bank actions that change this (market or shadow) price on reserve balances constitute the crucial first stage of the transmission of monetary policy. ### Implications of using reserve money as the operating target - Using reserve money as the operating target for day-to-day policy operations can severely hamper policy transmission and market development (illustrated in Figure 1). ### Flexible Monetary Targeting (FMT) and Enhanced Monetary Policy Analysis (EMPA) - Operations that ensure more stable and predictable short-term rates can be compatible with retaining a role for monetary aggregates. - EMPA: monetary aggregates mainly serve as indicators and cross-checks. - FMT: retains a role for money targets while providing flexibility for day-to-day management of excess reserves to facilitate smoother short-term interest rate development. - Laurens and others (2015) outline two FMT options: - Option 1: operations focus on keeping quantities on a path consistent with meeting reserve money targets, but total reserves, not reserve money, is the operating target. - Option 2: money aggregates have no operational role and are only used as intermediate targets (possibly together with other forward-looking indicators and analysis) to guide the setting of short-term interest rates, which serve as the de facto operating target. ### Flexible Monetary Targeting — Option 1 (quantity-focused with total reserves operating target) - Sources of high-frequency volatility when reserve money is the operating target: 1. Excessive focus on achieving end-period targets with little day-to-day management of excess reserves. 2. Focusing operations on keeping reserve money on a predetermined daily path so daily swings in currency holdings generate opposite swings in total and excess reserves. - Measures to reduce day-to-day volatility: - Set reserve money targets over a prespecified period (for example, quarterly), on average terms, and possibly within a band. - Set a path for total reserves consistent with the longer-term reserve money target and use this derived path for total reserves as the operating target. - Active liquidity management required: - Use flexible-rate fixed-quantity OMOs to offset autonomous factors and keep total reserves on target. - Requires accurate short-term forecasts of autonomous liquidity factors and lengthening the liquidity forecasting horizon to cover the entire horizon of the medium-term reserve money target. - Combine quantity-based operations with an interest rate corridor to cap changes in short-term interbank market interest rates: - Corridor formed by an overnight standing lending facility and an overnight standing deposit facility. - Standing facility rates should be fixed and not tied to market rates; access should be unlimited and automatic at initiation to provide a firm ceiling and floor. - The lending facility should be collateralized with appropriate haircuts; the collateral pool must be sufficiently wide. - Tradeoffs and constraints: - Not compatible with using a central bank policy rate to signal the policy stance if total reserves are the operating target—cannot simultaneously operate with both a short-term market interest rate and total reserves as the target for daily liquidity management operations. - Corridor may need periodic repositioning if market rates persistently hit floor or ceiling; repositioning serves as a policy signal. - Width of corridor matters: - Narrow corridor: keeps interest rates stable but requires more frequent repositioning and may muddle policy if reversed frequently. - Wider corridor initially provides flexibility; should be narrowed as central bank gains operational experience and improves liquidity forecasting capacity. - Automatic feedback loop: - Quantity-based framework creates an automatic feedback loop from broad money growth to short-term market rates: if required reserves grow faster than total reserves target, liquidity tightens and interbank rates rise; conversely if required reserves grow slower, liquidity loosens and interbank rates fall. - Advantage: helps ensure policy discipline and facilitate keeping interest rates high enough to ensure low and stable inflation when facing severe fiscal dominance or political pressure to keep rates too low. - Disadvantage: may cause unwarranted changes in short-term interest rates if broad money shifts are not correlated with future inflation; transmits lower-frequency volatility in broad money to interest rates via required reserves. - Operational details: - Autonomous factors include currency in circulation, net government position with the central bank, and central bank foreign exchange interventions. - Operations frequency: - Daily operations needed without reserve averaging. - With reserve averaging permitted, two to three operations within the maintenance period (MP)—one at the first day, possibly one in the middle, and a fine-tuning operation at the end—could suffice. - Total reserves and reserve money for these purposes should include all liquid balances commercial banks have on their various accounts at the central bank, including balances on interest-earning overnight deposit accounts, but not non-liquid deposits such as one- to two-week certificates of deposit. ### Flexible Monetary Targeting — Option 2 (interest-rate-focused with money aggregates as intermediate targets) - Framework: - Fully interest-rate-based operational framework combined with a role for (broad) money aggregates as intermediate targets or information variables to guide interest rate setting. - Shifting the operating target to a short-term interest rate allows a policy rate to signal the policy stance and, with effective liquidity management, strengthens policy communication and transmission. - Money-based instrument rule for adjusting the policy rate: - ∆ii_t = f(ṁ_{t−1} − ṁ_{t−1}^*) - Where ṁ_{t−1} is observed money growth and ṁ_{t−1}^* is the target growth assumed consistent with keeping inflation on target. - Forward-looking targeting rule: - ii_t = φ i_t^* + (1−φ) i_{t−1} - Where i_t^* is the estimated rate that ensures 퐸퐸_{t−1}(ṁ_t | i_t) = ṁ_t^*. - Replacing automatic quantity feedback with information feedback: - Option 2 removes the automatic feedback loop from money targets to short-term rates present in option 1, replacing it with an information feedback loop that uses money aggregates among other indicators. - Tradeoffs: - Option 2 provides less political cover to adjust interest rates than option 1. - It provides more flexibility to incorporate insights from multiple analytical tools and indicators about the inflation outlook, facilitating a gradual transition toward an inflation-targeting framework. ### Configuration of interest-rate-focused operational frameworks in LLMICs - Centerpiece: a policy rate serving as the operating target for a short-term interbank market rate (typically the secured or unsecured overnight interbank rate) that signals the policy stance. - Policy rate constitutes a de facto commitment for the central bank to use OMOs to keep the targeted market rate close to the target. - Standing lending facilities act as a ceiling; interest-earning deposit facilities increasingly used as a policy rate or a floor. - Differences across frameworks include: - Maturity of OMO instruments. - Whether issued at flexible-rate fixed-quantity auctions or at a fixed price with full allotment. - Choice among configurations depends on: - Functioning of the money market. - Quality of central bank liquidity forecasting. - Consistency with the goal of facilitating financial market development. - Structural liquidity situation and whether the central bank is primarily injecting or mopping up liquidity. - Cost implications typically broadly similar and not the central consideration. ### Three main configurations of interest-rate-focused frameworks - Conventional flexible-rate fixed-quantity system: - Central bank uses flexible-rate fixed-quantity auctions of central bank or government paper to manage liquidity and offset autonomous factors. - Some central banks set ceilings or floors for bids to signal the target rate. - Floor system: - Interest rate on the central bank’s overnight deposit facility (or on excess reserves) is the policy rate and operating target. - OMOs aim to keep the market sufficiently long so short-term interbank market rates are at the floor. - Fixed-at-the-policy-rate full-allotment system: - Central bank offers short-term liquidity injecting or absorbing instruments at the policy rate and at the full amount demanded (no amount announced in advance). - Policy rate typically positioned in the middle of a corridor set by standing facilities. ### The conventional flexible-rate fixed-quantity system — details and tradeoffs - Most demanding to operate; two versions: with and without an interest-earning deposit facility. - Both versions require accurate short-term forecasts of autonomous liquidity factors and capacity for frequent fine-tuned OMOs. - Rely on well-functioning and deep interbank markets so: 1. Banks can predictably place surplus liquidity with and obtain short-term funding from each other at rates close to the policy rate. 2. Shocks to precautionary demand for reserves or credit risk factors do not cause undue volatility. - Version with interest-bearing deposit facility generally less demanding: - If interest rate target positioned in the middle of the corridor formed by standing facilities, OMOs may aim at keeping excess reserves constant even when changing policy stance, because equal changes in standing facility rates change the opportunity cost of being short or long and thus shift reserve demand in parallel. - Positioning the target in the corridor midpoint makes the market less vulnerable to shocks to banks’ precautionary demand for reserve balances. - Empirical and theoretical considerations: - Demand for overnight reserve balances can be very interest-elastic within a maintenance period under reserve averaging, but very interest-inelastic on the last day of the maintenance period and over the longer term. ### Box 1. The Demand for Reserve Balances and the Role of Standing Facilities — main findings - Banks’ demand for overnight reserve balances is closely linked to the volatility of interbank payment flows and the associated risk and cost of being short or long at settlement closure. - The central bank can influence interbank market interest rates by: - changing the supply of reserves, thereby the probability of banks ending the day short or long; and/or - changing the rates on its standing facilities and thus the cost to banks of ending the day short or long, which causes the reserve demand curve to shift. - Mechanical effects illustrated: - Changing the central bank lending rate alters the cost to banks of ending the day short, tilts the demand curve, and changes the interbank rate for a given supply of reserves. - Introducing a deposit facility / paying interest on excess reserves tilts and flattens the demand curve and causes the interbank rate to rise for a given supply of reserves. - Reducing central bank lending and deposit facility rates shifts the demand schedule downward and reduces the interbank rate for a given supply of reserves. ### Appendix II — models and operational implications - Two complementary models yield relationships among reserves, the interbank interest rate, standing facility rates, and payment shock risks: - Individual bank model (Section B) - Aggregate interbank market model (Section C) - Individual bank model — key elements and results: - Notation: R, S, P, f(P), RR, i, i_L^CB, i_D^CB. - Benchmark without interest-earning deposit facility: - Bank minimizes: i·R + ∫_{P=R−RR}^{P=Ṕ} i_L^CB·(P−(R−RR))·f(P) dP. - First-order condition (equation (2)): i − i_L^CB · ∫_{P=R−RR}^{Ṕ} f(P) dP = 0 <=> i = i_L^CB · (1 − F(R − RR)) / 2. - Slope of demand curve (equation (3)): d i / d R = − i_L^CB · f(R − RR). - Benchmark with interest-earning deposit facility: - Bank minimizes: i·R − ∫_{P=−Ṕ}^{P=R−RR} i_D^CB·((R − RR) − P)·f(P) dP + ∫_{P=R−RR}^{P=Ṕ} i_L^CB·(P − (R − RR))·f(P) dP. - First-order condition (equation (5)): i = i_L^CB · (1 − F(R − RR)) + i_D^CB · F(R − RR) = i_D^CB + (i_L^CB − i_D^CB) · (1 − F(R − RR)). - Slope (equation (6)): d i / d R = − (i_L^CB − i_D^CB) · f(R − RR). - Implication: narrowing the interest rate corridor reduces interbank rate volatility even if banks do not access facilities. - Aggregate market model: - Market-clearing relation (equation (7)): i = i_L^CB · P(short) + i_D^CB · P(long), with P(short) + P(long) = 1. - Perceived probabilities depend on the central bank’s operating target clarity and track record. - Operational recommendation: conducting OMOs late in the day, when autonomous flows known, reduces intervention errors and interbank rate volatility. ### The Floor System (Appendix II) - Description: - Central bank provides sufficient excess reserves so the overnight market rate stays close to the policy rate (floor). - Once rates are at the floor, demand for reserves tends to become perfectly elastic; price and quantity decouple when excess reserves large. - Advantages: - Reduces need for fine-tuned day-to-day liquidity operations. - Allows control of both interest rates and liquidity and provision of emergency liquidity assistance without causing rates to fall. - Makes market rates less vulnerable to precautionary demand shocks. - May reduce banking costs and interest rate spreads by providing abundant reserves earning close to the overnight interbank rate; paying interest on excess and required reserves would eliminate the “reserve tax.” - Objections and counterarguments: - Objection: weaker policy transmission due to reduced interbank trading and reduced competition for deposits. - Counterarguments: - Banks still mobilize deposits if deposit rates cheaper than marginal opportunity cost of reserves. - Transmission to retail deposit rates could be stronger when interbank market is dysfunctional. - Deposit facility anchors pricing of longer-term instruments when overnight interbank markets are dysfunctional. - Mitigating reduced interbank trading: - Do not supply more reserves than strictly needed to keep rates at the floor. - A tiered rate structure for the deposit facility can mitigate reluctance of long banks to lend. ### The Fixed-Rate Full-Allotment System (Appendix II) - Characteristics: - Shares many benefits of the floor system but may entail higher liquidity risks. - Full-allotment reduces need for accurate short-term liquidity forecasting and fine-tuned OMOs. - Differs from floor system by instrument maturity, operation frequency, and timing. - Can be used regardless of whether structural liquidity position is long or short. - Operational implications: - Longer-term instruments and less frequent operations tend to leave uneven distribution of excess reserves, increasing interbank trading need but increasing short-term liquidity risk. - Requires a better functioning interbank market for banks to manage liquidity risks. ### Optimal width of the interest rate corridor (Appendix II) - Tradeoffs: - Corridor too wide may hamper market development and policy transmission, lead to reserve hoarding and high day-to-day interest rate volatility. - Narrow corridor reduces incentives for overnight interbank trading but better anchors short-term rates, aiding development of longer-term instruments and strengthening transmission in underdeveloped markets. - Country evidence (Table 1: Interest Rate Corridor Width in Selected Countries): - Columns: 2008 | 2013 - 50bp and less: - 2008: Australia, Canada, Chile, Malaysia, New Zealand - 2013: Australia, Canada, Chile, Colombia, Czech Republic, Israel, Kazakhstan, Malaysia, New Zealand - 75bp: - 2008: Jordan, United Kingdom - 2013: (no entries) - 100-149bp: - 2008: Norway, Singapore, South Africa, Thailand - 2013: Afghanistan, Egypt, Fiji, Norway, Thailand, Tunisia - 150-199bp: - 2008: Afghanistan, Iceland, Sweden - 2013: Euro area, Sweden, Peru - 200bp: - 2008: Czech Republic, Hungary, Israel, Papua New Guinea, United Kingdom - 2013: Argentina, Colombia, DRC, Costa Rica, Dominican Republic, Guatemala, Hungary, Indonesia, Korea, Morocco, South Africa - More than 200bp: - 2008: Albania, Cape Verde, Croatia, Dominican Republic, Indonesia, Poland, Romania, Serbia - 2013: Albania, Bhutan, Brazil, Croatia, Honduras, Iraq, Mauritius, Moldova, Mongolia, Mozambique, Nigeria, Romania, Rwanda, Serbia - Source of table: IMF ISMP database. - Other considerations: - High interest rate levels and other volatility-absorption mechanisms could justify a wider corridor. - Reserve averaging over a sufficiently long maintenance period can help absorb liquidity shocks. - High interest rate levels may justify a wider corridor because policy rate adjustments tend to be larger in absolute terms, the higher the interest rate level. ### Implications for central bank costs (Appendix II) - Costs and challenges: - Managing liquidity to keep short-term rates stable and aligned with the policy rate can be costly, especially when structural liquidity surpluses are large. - Under conventional flexible-rate fixed-quantity and fixed-rate full-allotment systems most structural surplus liquidity would be drained through OMOs; under the floor system surplus would be remunerated at the deposit rate. - Central banks may rely on un-remunerated reserve requirements during transition, which act as a tax on the banking system and widen retail interest rate spreads. - Failing to drain or remunerate excess reserves could lead to below-target market rates and a looser-than-intended policy stance; periodic draining to save costs risks high liquidity risk, volatile interest rates, high risk premiums, a steeper yield curve, and weak policy transmission. - Factors mitigating higher costs of a floor system: - Precautionary demand for overnight balances can be very low and the use of the deposit facility close to zero in a well-managed mid-corridor system; theory suggests precautionary demand should be zero when the target is at the middle of the corridor and payment shock distribution is symmetric with zero mean. - Cost of paying interest on excess reserves could be partly or fully offset by reduced OMO costs under a floor system. - Alternative to remunerating excess reserves is mopping up with longer-maturity OMO instruments, which typically carry a small but positive term premium relative to the deposit facility. - Empirical examples: - In New Zealand, the spread between the policy rate and the 30-day bank bill averaged 17bps in 2010-14 under a two-tier floor system. - In Norway interbank rates were on average around 20-30 bps above the deposit rate in 2010-2011 when operating a conventional floor system. - Conclusion: moving to a floor system could in fact result in lower central bank costs compared to a well-managed mid-corridor system without a deposit facility when excess reserves would otherwise be low. ### Summary and conclusions (selected) - Improving the operational framework is central for countries modernizing their monetary policy framework; shortcomings in operational frameworks and weak liquidity management are major obstacles to effective monetary policy in LLMICs. - Short-term interest rates, not reserve money, should in most cases be the daily operating target, including for countries relying on a money targeting strategy, because policy operations primarily work through interest rates, liquidity risk, yields, the exchange rate, and expectations. - Compatibility with monetary aggregates: - An operational framework that ensures stable and predictable short-term interest rates can be compatible with a role for monetary aggregates as intermediate targets or information variables to guide the interest rate target. - Countries wanting to retain an operational role for reserve money can use a path for total reserves derived from term reserve money targets as the operating target for daily liquidity management; this quantity-based framework can be combined with a firm interest rate corridor but would be incompatible with having a central bank policy rate to signal policy stance. - Framework selection depends on country-specific circumstances and on: 1. dependence on a well-functioning interbank market; 2. need for highly accurate central bank liquidity forecasting; 3. reliance on interbank market vs central bank facilities for short-term fund intermediation; 4. incentives for short-term interbank trading; 5. how well the framework anchors the lower end of the yield curve and facilitates transmission when markets are not well functioning. - General observations: - The conventional flexible-rate fixed-quantity system is the most demanding: requires accurate short-term forecasts, frequent OMOs, and well-functioning deep interbank markets, though it provides stronger incentives for active overnight interbank trading. - Floor and fixed-rate full-allotment systems are simpler and more robust, do not require a well-functioning interbank market (the floor system can work without a functioning overnight interbank market), and do not require highly accurate short-term liquidity forecasting. Policy transmission could be stronger under these systems when central bank liquidity management capacity is weak or markets are underdeveloped. - Research gaps: - Further empirical work needed on transmission strength under alternative operating configurations and how this depends on country circumstances. Open questions include the role of overnight interbank activity, appropriate size of central bank balance sheets, whether transmission is stronger when central banks operate from a structurally short position, and benefits of reserve averaging with less frequent OMOs and longer maturity instruments. ### Appendix I — interest rate volatility and alignment (figures scope) - Sources include central banks of Kenya, Malawi, Mauritius, Tanzania, Ghana, Indonesia, Uganda, Zambia, New Zealand, Norway, United States, United Kingdom, Czech Republic, Euro Area, Sweden, and Thailand. - Figures explicitly depict spreads (interbank − policy rate) and show policy and interbank rate series with annotations such as Corridor, Lending facility, Standing facilities, Min bid rate, Fixed refinance rate and specific time ticks (e.g., Ja n-0 1, Ja n-0 3, 3- Jan -03, 31 -D ec- 07, Ju l- 11). ### Appendix III — monetary policy transmission channels (selected) - Monetary policy works through impacts on: - interest rates, - explicit and implicit yields, - liquidity risk, - the exchange rate, - and expectations. - Reserve balances and payment-system interactions are the first stage of transmission: - Reserve balances are used for interbank transactions and settlement; total stock of reserves can only change through transactions with non-bank account holders. - Operating with a close-to-zero overnight balance target requires a narrow interest rate corridor, solid liquidity forecasting, frequent OMOs, a well-functioning interbank market, coordinated payment settlement timing, and ample intra- and inter-day credit facilities. - Direct interest rate channel: - Often weak in developing countries; strength depends on pass-through from policy to lending, deposit, and security rates and on interest-rate sensitivity of spending. - In high-risk, underdeveloped markets, policy rate changes may be absorbed by changes in risk premium, weakening pass-through. - Other channels covered: wealth and credit channels, risk channel, bank capital channel, and the exchange rate channel (summarized in the provided excerpts). ### Introduction — money creation, reserves, and banks' funding needs (selected) - Banks in aggregate do not strictly need reserve balances at the central bank in order to lend; deposits are created when banks lend. - Banks need reserves and other defensive liquid assets to manage liquidity risks from payment outflows and potential deposit withdrawals. - Defensive assets include reserves and government securities usable for settlement, liquidation, or collateral. - The total stock of reserves provides an upper limit to balance sheet expansion if reserve requirements exist; with reserve requirements, liquidity risks increase as excess reserves fall unless the central bank injects more reserves. - With a well-functioning interbank market, increased liquidity risk is reflected in higher interbank interest rates; with a poorly functioning interbank market, it is reflected in a shadow price on liquidity and a liquidity risk premium. *Source: wpiea2020026-print-pdf* ### References ............................................................................................................. ### wpiea2020026-print-pdf - References ### Key findings on operational frameworks and liquidity management - Shortcomings in operational frameworks and weak liquidity management are major obstacles for effective monetary policy implementation in many low- and lower-middle income countries (LLMICs). - Daily variation in overnight interbank rates is large in many LLMICs, in stark contrast to in advanced countries (Figure 1 and Appendix I). - Interbank rates have not been aligned with the policy rate in many LLMICs that use a policy rate to signal the policy stance; the spread has been at times both large and semi-persistent, with periodic large shifts. - For some countries, the difference between the policy rate and interbank rates is so large and the relationship so weak that the policy rate may have had little effect on commercial banks’ liquidity management and pricing decisions. - Consequences of misaligned or volatile short-term rates include: - High short-term liquidity risk. - Dilution of policy signals and weak monetary policy transmission. - Difficulty building central bank credibility. - Potential weakening of bank competition by creating arbitrage opportunities that favor larger banks with analytical capacity. ### Three critical issues for reforming monetary policy frameworks in LLMICs - How to choose an operating target for central banks’ daily liquidity management in countries where: - monetary aggregates traditionally have played a central role in guiding and implementing monetary policy; and - financial markets are underdeveloped and the policy transmission and the direct interest rate channel are weak. - How countries that want a continued role for monetary targets in their policy strategy can combine this with an operational framework that ensures more stable and predictable short-term interest rates. - How to best configure an interest-rate-focused operational framework in LLMICs, including pros and cons of alternative configurations and how the choice might depend on: - the policy framework; - the degree of market development; - the central bank’s liquidity forecasting capacity; - and how the configuration may hamper or foster the development of security markets. ### Operational framework taxonomy and roles - A fully specified monetary policy framework comprises: - The primary objective of monetary policy (typically price stability). - The policy strategy and policy formulation framework (helps set the level of the operating target; intermediate targets for a monetary aggregate help map policy objectives to operations under a MT policy strategy). - The operational framework (operating target and monetary instruments the central bank uses to manage excess reserves and the interbank market conditions necessary to achieve the operating target). - Main operational tools: standing lending and deposit facilities (commercial banks can freely access at their discretion) and open market operations (OMOs). - Definition note: “Excess reserves” are defined as all liquid balances commercial banks have on their various reserve, overnight, and current accounts at the central bank in excess of required reserves, irrespective of whether all of these funds count against the reserve requirement; it excludes term deposits. ### Central thesis on the choice of operating target - Short-term interest rates should in most cases be the operating target for day-to-day monetary policy operations, even in countries that rely on a money-targeting policy strategy. - Two main reasons: - Monetary policy operations mainly work through their impact on market interest rates and yields, liquidity risk and risk premiums, the exchange rate, and expectations (Figure 3 and Appendix III). - Policy transmission to rates that influence private sector behavior—rates on longer-term securities, deposit, and lending rates—should be stronger when monetary operations ensure stable and predictable short-term rates. ### Requirements for effective policy transmission - Policy operations need to ensure: - Consistency between policy signals and actions. - That banks can predictably place surplus liquidity with, and obtain short-term funding from, each other or the central bank at rates that are reasonably stable and predictable. - Clear policy signals must be both credible and relevant; relevance requires that banks can obtain or place funds at the signaled short-term rate. - Large spreads between the policy rate and short-term market rates imply the policy rate is neither a credible nor a relevant signal and may weaken transmission. - Highly volatile short-term rates are hard to predict and impede financial market development. ### Role of OMOs and standing facilities in setting short-term rates - The central bank’s ability to control short-term interbank rates derives from: - Control over the total stock of reserve balances (commercial bank deposits at the central bank). - The terms for borrowing or depositing such funds with it (standing lending and deposit facilities). - Commercial banks use reserve balances for interbank transactions and for transactions with the central bank and government; they cannot lend them out or transfer them to entities without central bank accounts. - Banks face daily payments resulting in a risk of ending the day short or long of reserves; those short must access the central bank’s standing lending facility (if available) to avoid failing interbank payments or reserve requirements. - OMOs influence the risk of the market ending the day short or long; the terms of the standing facilities (and penalties) determine the cost. The market or “shadow” price on reserves and the risk of being short or long determine overnight interbank rates when markets function; when markets are poorly functioning, a shadow price on reserves emerges (Appendix II). - Central bank actions that change this (market or shadow) price on reserve balances constitute the crucial first stage of the transmission of monetary policy. ### Implications of using reserve money as the operating target - Using reserve money as the operating target for day-to-day policy operations can severely hamper policy transmission and market development (illustrated in Figure 1). *Source: wpiea2020026-print-pdf* ### Appendix I, it is often associated with highly volatile and unpredictable short-term market ### Appendix I, it is often associated with highly volatile and unpredictable short-term market rates. ### Flexible Monetary Targeting — Introduction and background - Operations that ensure more stable and predictable short-term rates can be compatible with retaining a role for monetary aggregates. - Two broad transitional arrangements discussed: Flexible Monetary Targeting (FMT) and Enhanced Monetary Policy Analysis (EMPA). - EMPA: monetary aggregates mainly serve as indicators and cross-checks. - FMT: retains a role for money targets while providing flexibility for day-to-day management of excess reserves to facilitate smoother short-term interest rate development. - Laurens and others (2015) outline two FMT options: - Option 1: operations focus on keeping quantities on a path consistent with meeting reserve money targets, but total reserves, not reserve money, is the operating target. - Option 2: money aggregates have no operational role and are only used as intermediate targets (possibly together with other forward-looking indicators and analysis) to guide the setting of short-term interest rates, which serve as the de facto operating target. ### Flexible Monetary Targeting — Option 1 (quantity-focused with total reserves operating target) Findings and operational features: - Two main sources of high-frequency volatility when reserve money is the operating target: 1. Excessive focus on achieving end-period targets with little day-to-day management of excess reserves. 2. Focusing operations on keeping reserve money on a predetermined daily path so daily swings in currency holdings generate opposite swings in total and excess reserves. - Measures to reduce day-to-day volatility: - Set reserve money targets over a prespecified period (for example, quarterly), on average terms, and possibly within a band. - Set a path for total reserves consistent with the longer-term reserve money target and use this derived path for total reserves as the operating target. - Active liquidity management required to offset autonomous changes in liquidity conditions. - Use flexible-rate fixed-quantity open-market operations to offset autonomous factors and keep total reserves on target. - Requires accurate short-term forecasts of autonomous liquidity factors and lengthening the liquidity forecasting horizon to cover the entire horizon of the medium-term reserve money target. - Combine quantity-based operations with an interest rate corridor to cap changes in short-term interbank market interest rates: - Corridor formed by an overnight standing lending facility and an overnight standing deposit facility. - Standing facility rates should be fixed and not tied to market rates; access should be unlimited and automatic at initiation to provide a firm ceiling and floor. - The lending facility should be collateralized with appropriate haircuts; the collateral pool must be sufficiently wide. - Tradeoffs and constraints: - Not compatible with using a central bank policy rate to signal the policy stance if total reserves are the operating target—cannot simultaneously operate with both a short-term market interest rate and total reserves as the target for daily liquidity management operations. - Corridor may need periodic repositioning if market rates persistently hit floor or ceiling; repositioning serves as a policy signal. - Width of corridor matters: - Narrow corridor: keeps interest rates stable but requires more frequent repositioning and may muddle policy if reversed frequently. - Wider corridor initially provides flexibility; should be narrowed as central bank gains operational experience and improves liquidity forecasting capacity. - Automatic feedback loop: - Quantity-based framework creates an automatic feedback loop from broad money growth to short-term market rates: if required reserves grow faster than total reserves target, liquidity tightens and interbank rates rise; conversely if required reserves grow slower, liquidity loosens and interbank rates fall. - Advantage: helps ensure policy discipline and facilitate keeping interest rates high enough to ensure low and stable inflation when facing severe fiscal dominance or political pressure to keep rates too low. - Disadvantage: may cause unwarranted changes in short-term interest rates if broad money shifts are not correlated with future inflation; transmits lower-frequency volatility in broad money to interest rates via required reserves. Operational details and clarifications: - Autonomous factors defined as changes in the central bank’s balance sheet that inject or withdraw reserves other than policy OMOs; main factors include currency in circulation, net government position with the central bank, and central bank foreign exchange interventions. - Operations frequency: - Daily operations would be needed in a system without reserve averaging. - If reserve averaging permitted, two to three operations within the maintenance period (MP)—one at the first day, possibly one in the middle, and a fine-tuning operation at the end—could suffice. - Reserve averaging gives banks flexibility and makes short-term market rates less sensitive to changes in the stock of reserves. - Definition guidance: - Total reserves and reserve money for these purposes should include all liquid balances commercial banks have on their various accounts at the central bank, including balances on interest-earning overnight deposit accounts, but not non-liquid deposits such as one- to two-week certificates of deposit. ### Flexible Monetary Targeting — Option 2 (interest-rate-focused with money aggregates as intermediate targets) Framework and rules: - Fully interest-rate-based operational framework combined with a role for (broad) money aggregates as intermediate targets or information variables to guide interest rate setting. - Shifting the operating target to a short-term interest rate allows a policy rate to signal the policy stance and, with effective liquidity management, strengthens policy communication and transmission. - A money-based instrument rule for adjusting the policy rate and operating target when money growth deviates from target: - ∆ii_t = f(ṁ_{t−1} − ṁ_{t−1}^*) - Where ṁ_{t−1} is observed money growth and ṁ_{t−1}^* is the target growth assumed consistent with keeping inflation on target. - A forward-looking targeting rule: - ii_t = φ i_t^* + (1−φ) i_{t−1} - Where i_t^* is the estimated rate that ensures 퐸퐸_{t−1}(ṁ_t | i_t) = ṁ_t^*. - Replacing automatic quantity feedback with information feedback: - Option 2 removes the automatic feedback loop from money targets to short-term rates present in option 1, replacing it with an information feedback loop that uses money aggregates among other indicators. - Tradeoffs: - Option 2 provides less political cover to adjust interest rates than option 1. - It provides more flexibility to incorporate insights from multiple analytical tools and indicators about the inflation outlook, facilitating a gradual transition toward an inflation-targeting framework. ### Configuration of interest-rate-focused operational frameworks in LLMICs — Introduction - Centerpiece: a policy rate serving as the operating target for a short-term interbank market rate (typically the secured or unsecured overnight interbank rate) that signals the policy stance. - Targets can be explicitly announced or implied by central bank operations (e.g., tied to an instrument or facility, or by setting minimum/maximum bid rates in flexible-rate fixed-quantity auctions). - Policy rate constitutes a de facto commitment for the central bank to use OMOs to keep the targeted market rate close to the target. - Standing lending facilities act as a ceiling; interest-earning deposit facilities increasingly used as a policy rate or a floor. - Differences across frameworks include: - Maturity of OMO instruments. - Whether issued at flexible-rate fixed-quantity auctions or at a fixed price with full allotment. - Choice among configurations depends on: - Functioning of the money market. - Quality of central bank liquidity forecasting. - Consistency with the goal of facilitating financial market development. - Structural liquidity situation and whether the central bank is primarily injecting or mopping up liquidity. - Cost implications typically broadly similar and not the central consideration. ### Three main configurations of interest-rate-focused frameworks - Conventional flexible-rate fixed-quantity system: - Central bank uses flexible-rate fixed-quantity auctions of central bank or government paper to manage liquidity and offset autonomous factors. - Some central banks set ceilings or floors for bids to signal the target rate. - Floor system: - Interest rate on the central bank’s overnight deposit facility (or on excess reserves) is the policy rate and operating target. - OMOs aim to keep the market sufficiently long so short-term interbank market rates are at the floor. - Fixed-at-the-policy-rate full-allotment system: - Central bank offers short-term liquidity injecting or absorbing instruments at the policy rate and at the full amount demanded (no amount announced in advance). - Policy rate typically positioned in the middle of a corridor set by standing facilities. ### The conventional flexible-rate fixed-quantity system — details and tradeoffs - Most demanding to operate; two versions: with and without an interest-earning deposit facility. - Both versions require accurate short-term forecasts of autonomous liquidity factors and capacity for frequent fine-tuned OMOs. - Rely on well-functioning and deep interbank markets so: 1. Banks can predictably place surplus liquidity with and obtain short-term funding from each other at rates close to the policy rate. 2. Shocks to precautionary demand for reserves or credit risk factors do not cause undue volatility. - Version with interest-bearing deposit facility generally less demanding: - Especially if interest rate target positioned in the middle of the corridor formed by standing facilities. - In the corridor version, the central bank may aim OMOs at keeping excess reserves constant even when changing policy stance, because equal changes in standing facility rates change the opportunity cost of being short or long and thus shift reserve demand in parallel. - Positioning the target in the corridor midpoint makes the market less vulnerable to shocks to banks’ precautionary demand for reserve balances. - Empirical and theoretical considerations: - It can be difficult to determine how much excess reserves must change to affect interest rates. - Literature finds demand for overnight reserve balances can be very interest-elastic within a maintenance period under reserve averaging, but very interest-inelastic on the last day of the maintenance period and over the longer term. *Source: Appendix I and Sections III–IV of the provided IMF content unit.* ### Box 1. The Demand for Reserve Balances and the Role of Standing Facilities 1/ ### Box 1. The Demand for Reserve Balances and the Role of Standing Facilities 1/ ### Main findings on reserve demand and interbank rates - Banks’ demand for overnight reserve balances is closely linked to the volatility of interbank payment flows and the associated risk and cost of being short or long at the time of settlement closure. - The central bank can influence interbank market interest rates by: - changing the supply of reserves, and thereby the probability of banks ending the day short or long; and/or - changing the rates on its standing facilities and thus the cost to banks of ending the day short or long, which causes the reserve demand curve to shift. ### Mechanical effects illustrated (scenarios) - Changing the central bank lending rate: - alters the cost to banks of ending the day short; - tilts the demand curve; - changes the interbank rate for a given supply of reserves. - Introducing a deposit facility / start paying interest on excess reserves: - tilts and flattens the demand curve; - causes the interbank rate to rise for a given supply of reserves. - Reducing central bank lending and deposit facility rates: - shifts the demand schedule downward; - reduces the interbank rate for a given supply of reserves. ### Model elements and notation used in figures - D: Demand for reserves at the close of the Market - RR: Required reserves - S: Supply of reserves - R: Reserve balances - P: Stochastic after-close-of-market payment shock - P is uniformly distributed within the interval [-Ṕ,Ṕ] - i: Interbank interest rate - i_L^CB: Central bank lending rate - i_D^CB: Central bank deposit rate ### Reference note - 1/ The figures are based on Ennis and Keister (2008), who provide a more in-depth discussion of this subject. See *Source: wpiea2020026-print-pdf - Box 1. The Demand for Reserve Balances and the Role of Standing Facilities 1/* ### Appendix II for the underlying model as well as a complementary aggregate market model. ### Appendix II for the underlying model as well as a complementary aggregate market model. ### The Floor System - Description: - The floor system requires the central bank to provide banks with sufficient excess reserves to ensure that the overnight market rate stays close to the policy rate. - Once interest rates are close to the floor, the demand for reserves tends to become perfectly elastic; the central bank can increase liquidity without pushing short-term interbank rates below the target. - Under a floor system price and quantity become “decoupled” once excess reserves are sufficiently large and rates are at the floor. - Advantages: - Reduces the need for fine-tuned day-to-day liquidity operations; the deposit facility will automatically drain excess if more reserves than needed are provided. - Allows the central bank to control both interest rates and liquidity and to provide emergency liquidity assistance without risking a liquidity-provided-induced decline in market interest rates. - Makes market rates less vulnerable to shocks to banks’ precautionary demand for reserve balances. - May reduce banking costs and interest rate spreads by providing abundant costless and safe reserves earning close to the overnight interbank rate; paying interest on excess and required reserves would eliminate the “reserve tax” and likely decrease the spread between lending and deposit rates. - Objections and counterarguments: - Objection: policy transmission could be weaker because (1) excess reserves could reduce competition for bank deposits; and (2) less need for overnight interbank trading. - Counterarguments: - Banks retain incentives to mobilize deposits if bid-up deposit rates are cheaper than the marginal opportunity cost of obtaining/placing reserve balances. Opportunity cost equals the interbank rate in a flexible-price fixed-quantity system and equals the interbank/deposit facility rate in a floor system. - Transmission to retail deposit rates could be stronger under a floor system when the interbank market is not functioning well. - The deposit facility provides a risk-free investment option (earning the policy rate) to anchor pricing of longer-term instruments and strengthen transmission along the yield curve when overnight interbank markets are dysfunctional. - Reducing short-term liquidity risk may flatten the yield curve, encourage longer-term lending, reduce liquidity risk premiums, and make longer-term rates more responsive to policy rate changes. - Mitigating reduced interbank trading: - Interbank trading volumes depend on distribution of excess reserves, trading costs, and counterparty risks. - Not supplying more reserves than strictly needed to keep rates at the floor increases the likelihood of some banks being short and seeking to borrow. - A tiered rate structure for the deposit facility (deposits above a predetermined amount remunerated at a lower rate) can mitigate reluctance of long banks to lend. ### The Fixed-Rate Full-Allotment System - Characteristics vs. floor system: - Provides many benefits of the floor system but may entail higher liquidity risks. - Both are full-allotment systems reducing the need for accurate short-term liquidity forecasting and fine-tuned OMOs. - Differences center on the maturity of the central bank instrument used, frequency of operations, and timing of operations. - The floor system requires a structural liquidity surplus; the fixed-rate full-allotment system can be used regardless of whether the structural liquidity situation is long or short. - Operational implications: - Using slightly longer-term instruments and less frequent operations tends to leave an uneven distribution of excess reserves, increasing the need and incentive for interbank trading but increasing short-term liquidity risk. - The fixed-rate full-allotment system requires a better functioning interbank market for banks to manage liquidity risks to the same degree as under a floor system. - Performance relative to conventional flexible-price fixed-quantity: - The conventional system may perform better when the central bank’s short-term liquidity forecasts are accurate because the fixed-rate full-allotment system effectively delegates aggregate forecasting to individual banks. - Evidence suggests banks tend to overbid for liquidity under fixed-rate full-allotment and that post-allotment interbank rates can dip below the tender rate. ### The Optimal Width of the Interest Rate Corridor - Tradeoffs: - A corridor set too wide may hamper market development and policy transmission and could lead to reserve hoarding and high day-to-day interest rate volatility, complicating banks’ liquidity management. - A narrow corridor reduces incentives for overnight interbank trading but better anchors short-term rates, aiding development of longer-term instruments and strengthening transmission along the yield curve in underdeveloped markets. - Country evidence (Table 1: Interest Rate Corridor Width in Selected Countries): - Columns: 2008 | 2013 - 50bp and less: - 2008: Australia, Canada, Chile, Malaysia, New Zealand - 2013: Australia, Canada, Chile, Colombia, Czech Republic, Israel, Kazakhstan, Malaysia, New Zealand - 75bp: - 2008: Jordan, United Kingdom - 2013: (no entries) - 100-149bp: - 2008: Norway, Singapore, South Africa, Thailand - 2013: Afghanistan, Egypt, Fiji, Norway, Thailand, Tunisia - 150-199bp: - 2008: Afghanistan, Iceland, Sweden - 2013: Euro area, Sweden, Peru - 200bp: - 2008: Czech Republic, Hungary, Israel, Papua New Guinea, United Kingdom - 2013: Argentina, Colombia, DRC, Costa Rica, Dominican Republic, Guatemala, Hungary, Indonesia, Korea, Morocco, South Africa - More than 200bp: - 2008: Albania, Cape Verde, Croatia, Dominican Republic, Indonesia, Poland, Romania, Serbia - 2013: Albania, Bhutan, Brazil, Croatia, Honduras, Iraq, Mauritius, Moldova, Mongolia, Mozambique, Nigeria, Romania, Rwanda, Serbia - Source of table: IMF ISMP database. - Other considerations: - High interest rate levels and the existence of other volatility absorption mechanisms could justify a wider corridor. - Requiring banks to meet reserve requirements on average over a sufficiently long maintenance period (rather than daily) can help absorb liquidity shocks. - High interest rate levels may justify a wider corridor because policy rate adjustments tend to be larger in absolute terms, the higher the interest rate level. ### Implications for Central Bank Costs - Costs and challenges: - Managing liquidity to keep short-term rates stable and aligned with the policy rate can be costly, especially when structural liquidity surpluses are large. - Under conventional flexible-rate fixed-quantity and fixed-rate full-allotment systems most structural surplus liquidity would be drained through OMOs; under the floor system surplus would be remunerated at the deposit rate. - Central banks may rely on un-remunerated reserve requirements during transition, which act as a tax on the banking system and widen retail interest rate spreads. - Failing to drain or remunerate excess reserves could lead to below-target market rates and a looser-than-intended policy stance; periodic draining to save costs risks high liquidity risk, volatile interest rates, high risk premiums, a steeper yield curve, and weak policy transmission. - Factors mitigating higher costs of a floor system: - Precautionary demand for overnight balances can be very low and the use of the deposit facility close to zero in a well-managed mid-corridor system; theory suggests precautionary demand should be zero when the target is at the middle of the corridor and payment shock distribution is symmetric with zero mean. - The cost of paying interest on excess reserves could be partly or fully offset by reduced OMO costs under a floor system. - In cases of large structural surplus, the alternative is mopping up reserves with longer-maturity OMO instruments, which typically carry a small but positive term premium relative to the deposit facility. - Empirical examples: in New Zealand, the spread between the policy rate and the 30-day bank bill averaged 17bps in 2010-14 under a two-tier floor system; in Norway interbank rates were on average around 20-30 bps above the deposit rate in 2010-2011 when operating a conventional floor system. - Conclusion: moving to a floor system could in fact result in lower central bank costs compared to a well-managed mid-corridor system without a deposit facility when excess reserves would otherwise be low. ### Summary and Conclusions - Operational framework importance: - Improving the operational framework is central for countries modernizing their monetary policy framework; shortcomings in operational frameworks and weak liquidity management are major obstacles to effective monetary policy in LLMICs. - Short-term interest rates, not reserve money, should in most cases be the daily operating target, including for countries relying on a money targeting strategy, because policy operations primarily work through interest rates, liquidity risk, yields, the exchange rate, and expectations. - Compatibility with monetary aggregates: - An operational framework that ensures stable and predictable short-term interest rates can be compatible with a role for monetary aggregates as intermediate targets or information variables to guide the interest rate target. - Countries wanting to retain an operational role for reserve money can use a path for total reserves derived from term reserve money targets as the operating target for daily liquidity management; this quantity-based framework can be combined with a firm interest rate corridor but would be incompatible with having a central bank policy rate to signal policy stance. - Framework selection considerations: - The optimal fully interest-rate-based framework depends on country-specific circumstances and on: (1) dependence on a well-functioning interbank market; (2) need for highly accurate central bank liquidity forecasting; (3) reliance on interbank market vs central bank facilities for short-term fund intermediation; (4) incentives for short-term interbank trading; (5) how well the framework anchors the lower end of the yield curve and facilitates transmission when markets are not well functioning. - General observations: - The conventional flexible-rate fixed-quantity system is the most demanding: it requires accurate short-term forecasts, solid capacity for frequent OMOs, and well-functioning deep interbank markets, though it provides stronger incentives for active overnight interbank trading. - Floor and fixed-rate full-allotment systems are simpler and more robust, do not require a well-functioning interbank market (the floor system can work without a functioning overnight interbank market), and do not require highly accurate short-term liquidity forecasting. Policy transmission could be stronger under these systems when central bank liquidity management capacity is weak or markets are underdeveloped. - Research gaps: - Further empirical work is needed on the strength of transmission under alternative operating configurations and how this depends on country circumstances. Open questions include the role of overnight interbank activity for transmission and market development, the appropriate size of central bank balance sheets, whether transmission is stronger when central banks operate from a structurally short position, and the benefits of reserve averaging with less frequent OMOs and longer maturity instruments. *Source: Appendix II (selected pages) of the provided IMF PDF content.* ### APPENDIX I. INTEREST RATE VOLATILITY AND ALIGNMENT IN SELECTED COUNTRIES ### APPENDIX I. INTEREST RATE VOLATILITY AND ALIGNMENT IN SELECTED COUNTRIES ### Figure scope and data sources - Sources: Central banks of Kenya, Malawi, Mauritius, and Tanzania. - Sources: Central banks of Ghana, Indonesia, Uganda, and Zambia. - Sources: Central banks of New Zealand, and Norway, the United States, and the United Kingdom. - Sources: Central banks of the Czech Republic, the Euro Area, Sweden, and Thailand. ### Figures and countries covered - Figure 1. Policy and Overnight Interbank Rates in Selected Low- and Middle-Income Countries - Countries shown: Kenya; Malawi; Mauritius; Tanzania; Ghana; Indonesia; Uganda; Zambia. - Plotted series and labels (as presented): - Spread (interbank - policy rate) - Interbank - Policy rate - Corridor - Lending facility - Standing facilities - 7-day interbank (Uganda labelled as "7- day interbank") - Specific axis tick labels and time markers as shown: - -7 - -2 - 3 - 8 - 13 - 18 - 23 - 28 - 33 - 38 - 3- Jan -03 - 3- Jan -05 - 3- Jan -07 - 3- Jan -09 - 3- Jan -11 - 3- Jan -13 - -3 - 2 - 7 - 12 - 17 - 22 - 27 - 3- Jan -12 - 3- Jan -13 - 3- Jan -14 - 3- Jan -1 - -6 - -4 - -2 - 0 - 2 - 4 - 6 - 8 - 10 - 12 - 14 - 31 -D ec- 07 - 31 -D ec- 09 - 31 -D ec- 11 - 31 -D ec- 13 - -7 - -2 - 3 - 8 - 13 - 18 - 23 - 28 - 33 - 38 - Ju l- 11 - Ju l- 12 - Ju l- 13 - Ju l- 14 - Figure 2. Policy and Overnight Interbank Rates in Selected Advanced Economy Countries - Countries shown: United States; New Zealand; Norway; United Kingdom; Euro Area; Sweden; Czech Republic; Thailand. - Plotted series and labels (as presented): - Spread (interbank - policy rate) / Spread (interbank - offical bank rate) / Spread (7-day interbank - policy rate) (country-specific label variations) - Interbank - Policy rate / Offical bank rate / Min bid rate (variable rate tenders) / Fixed refinance rate - Standing facilities / Standing f aci lit i es / Sta nd in g f aci lit i es - Specific axis tick labels and time markers as shown: - -2 - -1 - 0 - 1 - 2 - 3 - 4 - 5 - 6 - 7 - Ja n-0 1 - Ja n-0 3 - Ja n-0 5 - Ja n-0 7 - Ja n-0 9 - Ja n-1 1 - Ja n-1 3 - Oc t-0 6 - Oc t-0 8 - Oc t-1 0 - Oc t-1 2 - Oc t-1 4 - Ja n-0 1 - Ja n-0 3 - Ja n-0 5 - Ja n-0 7 - Ja n-0 9 - Ja n-1 1 - Ja n-1 3 - Ja n-1 5 - Ja n-0 1 - Ja n-0 3 - Ja n-0 5 - Ja n-0 7 - Ja n-0 9 - Ja n-1 1 - Ja n-1 3 - Ja n-1 5 - Ja n-0 1 - Ja n-0 3 - Ja n-0 5 - Ja n-0 7 - Ja n-0 9 - Ja n-1 1 - Ja n-1 3 - Ja n-1 5 - Figure 2. Policy and Overnight Rates in Selected Advanced Economy Countries (Continued) - Countries shown (continued): Euro Area; Sweden; Czech Republic; Thailand. - Plotted series and labels (as presented): - Spread (interbank - policy rate) - Interbank - Min bid rate (variable rate tenders) - Fixed refinance rate - Sta nd in g f aci lit i es - Specific axis tick labels and time markers as shown: - -2 - -1 - 0 - 1 - 2 - 3 - 4 - 5 - 6 - 7 - Ja n-0 1 - Ja n-0 3 - Ja n-0 5 - Ja n-0 7 - Ja n-0 9 - Ja n-1 1 - Ja n-1 3 - Ja n-1 5 - -0 .5 - 0. 0 - 0. 5 - 1. 0 - 1. 5 - 2. 0 - 2. 5 - 3. 0 - 3. 5 - 4. 0 - 4. 5 - D ec- 10 - D ec- 11 - D ec- 12 - D ec- 13 - D ec- 1 ### Key features illustrated (as presented in the figures) - Comparative presentation of policy rates and overnight/interbank rates across low-, middle-, and advanced-economy central banks. - Explicit depiction of spreads (interbank minus policy rate) as a primary metric of alignment/volatility. - Use of monetary-policy operational instruments indicated on charts: - Corridor - Lending facility - Standing facilities - Min bid rate (variable rate tenders) - Fixed refinance rate *Source: APPENDIX I. INTEREST RATE VOLATILITY AND ALIGNMENT IN SELECTED COUNTRIES (figures and sources as presented).* ### APPENDIX II. DEMAND FOR RESERVES BALANCES, UNCERTAINTY, AND THE ROLE OF ### APPENDIX II. DEMAND FOR RESERVES BALANCES, UNCERTAINTY, AND THE ROLE OF STANDING FACILITIES ### A. Introduction - Banks use reserve balances at the central bank for interbank payments; individual banks face intra-day risk of ending the day short or long of reserves due to operational glitches, information or market failure, and late-in-the-day payment shocks. - Costs and incentives: - Ending the day short can require accessing the central bank’s standing lending facility or failing payments; ending the day long can forgo interest earnings from lending those funds. - Profit-maximizing banks trade off the opportunity cost of holding reserves against the expected cost of accessing the central bank lending facility. - Aggregate system risks: - Autonomous flows (e.g., purchases of currency, securities, or tax payments) can cause the banking system aggregate reserves to end the day short or long if not fully offset by same-day OMOs. - Banks incorporate both individual and aggregate end-of-day risk when bidding in OMOs, buying government securities, or lending in the interbank market. - The appendix develops two complementary models that yield the same relationships among reserves, the interbank interest rate, standing facility rates, and payment shock risks: - Individual bank model (Section B) - Aggregate interbank market model (Section C) ### B. The Individual Bank Model — setup and key results - Assumptions: - Banks are risk-neutral and profit maximizing. - Banks can borrow and lend reserves in a competitive interbank market at a known fixed interest rate i. - Central bank controls total reserves via OMOs. - After the interbank market closes, each bank faces a stochastic end-of-day payment shock P that affects its individual end-of-day reserve position but not the aggregate. - The shock P has density f(P); in a simplified linear case f is uniform on [-Ṕ, Ṕ], but may be bell-shaped more generally. - End-of-day required reserves RR, with RR ≥ 0. - Central bank standing lending rate i_L^CB and deposit rate i_D^CB may exist; no stigma or other costs accessing standing lending facility; central bank may or may not pay interest on excess reserves. - Notation: - R: Stock of reserves after market close and before the after-market payment shock. - S: Supply of reserves. - P: Stochastic end-of-day after-market-closure payment shock. - f(P): probability density-function for P. - RR: End-of-day required reserve position. - i: Overnight interbank interest rate. - i_L^CB: Central bank overnight lending rate. - i_D^CB: Central bank overnight deposit rate. - Benchmark case without an interest-earning deposit facility: - Opportunity cost of holding reserves = i·R. - Cost of accessing lending facility when payment outflow P ≥ (R − RR) = i_L^CB·(P − (R − RR)). - Bank minimizes: i·R + ∫_{P=R−RR}^{P=Ṕ} i_L^CB·(P−(R−RR))·f(P) dP (equation (1) in source) - First-order condition: i − i_L^CB · ∫_{P=R−RR}^{Ṕ} f(P) dP = 0 <=> i = i_L^CB · (1 − F(R − RR)) / 2 (equation (2) in source) - Interpretation: optimal R equates opportunity cost of one more unit of reserve with marginal expected cost of being short. - Comparative statics: - An increase in the central bank’s lending rate raises the interbank market rate and steepens the demand curve; market rate increases less than the lending facility increase. - With symmetric zero-mean payment shock, optimal behavior: - Aim at ending the day short regularly if i > 1/2 · i_L^CB. - Aim at ending the day long if i < 1/2 · i_L^CB. - Slope of the demand curve: d i / d R = − i_L^CB · f(R − RR) (equation (3) in source) - Boundary behavior: - If market rates = i_L^CB, banks indifferent about holding amounts between 0 and RR − Ṕ. - If market rates ≈ 0, banks prefer R > RR + Ṕ (precautionary reserves to avoid lending facility access). - Benchmark case with an interest-earning deposit facility: - Banks earn i_D^CB·((R − RR) − P) on reserves in the deposit facility when P ≤ (R − RR). - Bank minimizes: i·R − ∫_{P=−Ṕ}^{P=R−RR} i_D^CB·((R − RR) − P)·f(P) dP + ∫_{P=R−RR}^{P=Ṕ} i_L^CB·(P − (R − RR))·f(P) dP (equation (4) in source) - First-order condition: i = i_L^CB · (1 − F(R − RR)) + i_D^CB · F(R − RR) = i_D^CB + (i_L^CB − i_D^CB) · (1 − F(R − RR)) (equation (5) in source) - Interpretation: interbank rate equals weighted average of standing facility rates with weights equal to probabilities of being short (1 − F(R − RR)) or long F(R − RR). - Comparative statics and properties: - Equal increase in both i_L^CB and i_D^CB raises interbank rate equally with unchanged reserve holdings. - If rates are at the middle of the corridor and payment shock density symmetric zero mean, optimal R = RR (excess reserves = 0). - Aim to be short if interbank rate above corridor middle, long if below. - Demand depends on location of interbank rate relative to standing facility rates, not on absolute interest rate levels. - Slope of the demand curve: d i / d R = − (i_L^CB − i_D^CB) · f(R − RR) (equation (6) in source) - Implication: narrowing the interest rate corridor (reducing i_L^CB − i_D^CB) flattens the demand curve and reduces interbank rate volatility, even if banks do not access facilities. - Boundary behavior: - When market rates ≈ i_D^CB, banks want R > RR + Ṕ. - Demand curve linear under uniform P distribution between RR − Ṕ and RR + Ṕ; curved for bell-shaped distributions. - Payment-system and timing effects emphasized: - Risk to individual banks of becoming short or long depends on: 1. Timing and coordination of interbank settlement (gross vs net; real time vs lagged); 2. Risk of large imbalances in payment inflows/outflows during and at end of day; 3. Timing of closure of payment system and interbank market and risk of payments after closure. - Ensuring sufficient time for interbank trading after retail clearing reduces late-in-the-day unoffset shocks. ### B. Generalizations (extensions and special cases) - No or poorly functioning interbank market: - Short-term government securities or central bank OMO instruments become the relevant opportunity cost for holding excess reserves. - Long banks choose between holding excess reserves or buying short-term securities; short banks choose between bidding in liquidity-injecting OMOs or accessing the standing lending facility. - Basic problem structure remains similar but liquidity of instruments and OMO frequency matter. - No central bank intraday credit facilities: - Banks must consider risk of payment outflows during the next day that exceed reserves; model can be adapted by redefining payment shock. - Interest charges on intraday credit: - Expected daylight credit costs can provide a floor to the interbank market rate—banks will not lend below expected daylight credit cost. - Other extensions noted as important: - Reserve averaging, bank heterogeneity, market frictions and segmentation, transaction costs, prudential regulations, and maturity structure of OMOs (Bech and Keister (2013) show OMO maturity can strongly affect market rates when liquidity coverage ratios bind). ### C. The Aggregate Market Model — determination of the interbank rate - Aggregate end-of-day shortages or surpluses can arise if central bank does not fully offset autonomous flows. If aggregate short, some banks must borrow from central bank; if aggregate long, some must hold excess reserves. - With perfect knowledge: - If aggregate short, lenders could charge rates close to i_L^CB because borrowing banks’ alternative is costlier central bank lending. - If aggregate long, borrowers could borrow near i_D^CB. - In practice, banks lack knowledge of whether market will end short or long; if perceived probability of short and long are equal and bargaining power equal, the market-clearing interbank rate is in the middle of the interest rate corridor. - Formal relationship (aggregate model): i = i_L^CB · P(short) + i_D^CB · P(long), with P(short) + P(long) = 1 (equation (7) in source) - The market clearing rate is a stochastic variable equal to the weighted average of the standing facility rates, with weights given by perceived probabilities the market ends short or long. - Parallel with individual model: - Equations (5) and (7) are similar: both imply interbank rate equals weighted average of standing facility rates with weights reflecting probabilities of being short or long (individual vs market). - Perceived probability determinants and central bank practice: - Perceived probabilities depend on market participants’ understanding of the central bank’s operating target and framework, and the central bank’s commitment and track record in managing aggregate excess reserves to keep interbank rates aligned with the policy rate. - Recommendation (operational implication): conducting OMOs late in the day, when sign and size of autonomous flows are known, reduces central bank intervention errors and helps ensure perceived probabilities of the market ending short or long are even, thereby reducing interbank rate volatility and lowering demand for high-frequency liquidity forecasting. *Source: IMF Working Paper — APPENDIX II. DEMAND FOR RESERVES BALANCES, UNCERTAINTY, AND THE ROLE OF STANDING FACILITIES* ### APPENDIX III. MONETARY POLICY TRANSMISSION CHANNELS ### APPENDIX III. MONETARY POLICY TRANSMISSION CHANNELS ### A. Introduction - Monetary policy works through its impact on: - interest rates, - explicit and implicit yields, - liquidity risk, - the exchange rate, - and expectations. - The commonly termed “interest rate channel” is not necessarily dominant; other channels (credit, bank lending, wealth, risk appetite, bank capital) operate by propagating and amplifying the effects of changes in interest rates, liquidity risk, exchange rates, and asset yields. - There is broad consensus that consumption and investment demand are mainly functions of: - income, - interest rates, - wealth, - and the availability of credit, rather than money balances. - Money-in-utility models that give a causal role to real money balances typically imply this effect would be quantitatively small and largely irrelevant. - Modern central banks control the supply of “central bank money,” defined as currency in circulation and commercial banks’ deposits at the central bank (“reserve balances,” for short). Government deposits at the central bank are excluded from the standard definition of reserve money. - Only one part of central bank money—reserve balances—is typically used as a policy tool. - Reserve balances can be tiny relative to daily payment flows and the financial market, especially in countries without reserve requirements, and they can only be used for interbank transactions. - Understanding transmission requires tracing how central bank actions on the volume and terms of supply of reserve balances affect bank behavior and how those effects transmit, through arbitrage, to market interest rates and asset prices. ### B. Reserve Balances, the Payment System, and the Interbank Money Market — the First Stage of the Transmission Mechanism - Commercial banks use their deposits at the central bank—reserve balances—for interbank transactions, particularly for settling customer payments. - Reserve balances constitute a closed system: - Banks cannot unilaterally change the total amount of reserve balances in the system. - Banks cannot transfer or lend reserve balances to entities without a central bank account. - Banks can directly use reserve balances to transact with the central bank and central bank account holders (mainly other banks and the government) to: 1. settle interbank payments; 2. purchase or sell foreign exchange or government securities; 3. lend to the other account holders. - Most such transactions move reserve balances between accounts without changing the total stock of reserves in the system. - The total stock of reserves held by banks can only change through transactions with non-bank account holders. - Banks’ demand for reserve balances is closely linked to: - the working of the payment system, - the central bank’s liquidity management framework. - Payment-day characteristics: - Banks receive and make a large number of interbank payments each day. - Even if daily net flows are close to zero for each bank, there is always a risk of being short and unable to carry out payments or meet reserve requirements, or of having to access the central bank’s standing lending facility. - These outcomes can be costly; holding large unremunerated balances is also costly because those funds could be lent to banks that are short. - Banks’ demand for reserve balances beyond required reserves depends on: - the risk or cost of being short during the day, - the cost of holding unremunerated balances. - It is possible to operate with a close-to-zero aggregate overnight reserve balance target; examples include: - The Reserve Bank of New Zealand operated with a constant overnight reserve target of US$20 million for a time. - The Bank of England operated for a time with a constant overnight reserve target of ￡45 million, during a period in which the daily interbank payment flows were over ￡150 billion. - Bank of Canada operated with a zero target for overnight settlement balances for a short period, and subsequently with a small positive target, in their Large Value Settlement system. - Operating with a close-to-zero overnight balance target requires: - a narrow interest rate corridor, - solid liquidity forecasting, - frequent open market operations (OMOs), - a well-functioning interbank market, - well-coordinated payment settlements, - proper coordination between the closure of the payment system and the interbank market, - effective collateral handling, - ample access to intra- and inter-day credit facilities. - Banks do not need to hold large reserve balances, and the central bank does not necessarily have to change the aggregate supply of reserves to steer the interbank rate. - In a mid-corridor system with symmetric risks, banks’ demand for overnight excess reserves should be close to zero. - Under that system (and under a floor system), changing the rates on the central bank’s standing facilities can shift the demand schedule for reserve balances and thereby affect the interbank rate. ### C. Reserve Balances and Bank Lending: the Interest Rate, Credit, Bank Lending, and Bank Capital Transmission Channels - (Section heading present; substantive discussion begins beyond the supplied excerpt.) *Source: APPENDIX III. MONETARY POLICY TRANSMISSION CHANNELS, wpiea2020026-print-pdf* ### Introduction ### Introduction ### Money creation, reserves, and banks' funding needs - Banks in aggregate do not strictly need reserve balances at the central bank in order to lend in a modern credit economy; neither do they need deposits in order to lend. - Deposits are a liability—an “I Owe You” (IOU)—and are not an asset that banks can on-lend. - Deposits (broad money or “commercial bank money”) are created when banks engage in lending: lending simultaneously creates a claim on the customer and a deposit (an IOU) for the customer. - Lending is thus self-financed and banks do "print money” (subject to limits discussed in Tobin [1963]). - A bank may not need reserve balances to settle payments arising from lending if: - the transaction is with another account holder at the same bank; - all banks expand at the same pace so increased payment outflows are matched by increased payment inflows; or - the bank can draw on existing interbank credit lines. - In such cases, the supply of loans and associated deposit-money in the banking system would be determined primarily by interest rates and credit demand, as argued by the post‑Keynesian endogenous money school. - In practice, banks need to hold reserves and other highly liquid “defensive” assets to manage liquidity risks from liability-side payment outflows and potential large deposit withdrawals. - Defensive assets include reserves and government securities that can: directly settle interbank payments; be liquidated at relatively low cost; or be used as collateral for central bank or interbank market borrowing. - Banks typically try to lock in part of the liability side of their balance sheet (e.g., offering higher-earning time deposits or issuing longer-maturity debt) — banks do need funding in order to lend. - The total stock of reserves can provide an upper limit to balance sheet expansion if banks are required to hold reserves in proportion to liabilities (the classic money-multiplier framing); with reserve requirements, liquidity risks increase as excess reserves fall unless the central bank injects more reserves. - With a perfectly functioning interbank market, increased liquidity risk is reflected in higher interbank interest rates; with a poorly functioning interbank market, it is reflected in an increased shadow price on liquidity and a liquidity risk premium. ### The Direct Interest Rate Channel - The direct interest rate channel is often weak in developing countries; its strength depends on: - the degree of pass-through from monetary policy actions to lending, deposit, and security rates; and - the interest rate sensitivity of investment and consumer spending decisions. - Unclear policy signals, high risks, low financial inclusion (low credit-to-GDP ratios, low deposit-to-GDP ratios, and large shares of the population without bank accounts) may weaken pass-through and reduce the role of bank lending and deposits. - In a low-risk environment with well-developed financial markets and clear policy signals: - Lending rates should be closely linked to the central bank’s policy rate, or standing facility rates; banks lend as long as expected net return is positive, which should be close to the policy rate in systems with a relevant policy rate. - When expanding lending, banks can cover additional interbank payment outflows by: (1) drawing on reserve balances; (2) borrowing from other banks or drawing on credit lines; (3) reducing holdings of securities by selling them to other banks or the central bank, or not rolling them over; or (4) attracting new deposits by offering better terms. The full opportunity cost of each option should be equal and equal to the policy rate/interbank rate. - Deposit rates should also be closely linked to retail lending rates, the policy rate, and security rates; the public must be willing to hold the additional liquidity created by lending. - Commercial banks’ demand for government securities should strengthen the link between monetary policy and security yields; government securities are close substitutes to reserve balances as “defensive” assets and are often usable as collateral. - Well-developed capital markets strengthen the link between security yields and bank lending/deposit rates by providing alternatives for funding and placing funds. - In high-risk environments with underdeveloped financial markets, weak credit culture, limited contract enforceability, and unclear policy signals: - Banks rely more on customer relationships, collateral, and non-price factors, which can slow pass-through of policy changes. - Small changes in the policy rate may be absorbed by changes in the risk premium when risk premia are a high proportion of retail lending rates, blunting policy transmission. - Weak competition and wide spreads between deposit and lending rates further undermine transmission. - Unclear policy signals and inappropriate operations fragment markets, increase liquidity cost heterogeneity across banks, weaken competition, and slow pass-through. - Even in such environments, there may still be a strong link between monetary policy and government security yields because banks often dominate government securities markets and use them as collateral for short-term funding; security yields often serve as the formal or de facto pricing base for loans and deposits in countries with no policy rate and no or highly volatile interbank rates. ### Monetary Policy, Lending Risk, Asset Prices, and the Wealth and Credit Channels - Changes in interest rates affect households’ and businesses’ cash-flow and cause asset prices to change, both of which affect credit demand and banks’ willingness to lend. - Persistent changes in asset prices impact consumption, saving, and investment decisions via the “wealth effect” and by affecting market value/book value ratios for enterprises. - Asset price changes alter borrowers’ balance sheets and collateral values, affecting perceived and actual lending risk and required risk premia. - Changes in borrowers’ cash-flow positions influence creditworthiness and directly affect liquidity-constrained households’ consumption and small businesses’ ability to expand. - Interest rate changes affect the cost of working capital and operating costs for businesses. - The overall economic outlook changes caused by monetary policy influence perceived lending risk and banks’ willingness to lend. - These effects amplify monetary policy impacts on the real economy but can also give rise to destabilizing asset bubbles. ### Monetary Policy and the Risk Channel - Interest rate changes can directly impact banks’ risk appetite, risk perception, and willingness to lend, amplifying monetary policy effects on the real economy through: - Credit rationing in a high interest rate environment (adverse selection may lead banks to curtail credit rather than raise rates). - Search for yields and higher risk appetite in a low interest rate environment (low returns on existing projects may incentivize lenders to take on more risk). - Changes in observed volatility and risk measures: policy-induced asset and collateral value changes affect estimates of probability of default, loss-given-default, and volatility (e.g., low interest rates and rising asset prices tend to reduce asset price volatility and risk perception). ### Capital Requirements and the Bank Lending Channel - Monetary policy may affect bank lending and lending rates through impacts on banks’ balance-sheet strength and capital requirements. - Banks subject to capital requirements may need to raise additional capital as they expand lending; bank capital conditions affect ability to raise capital, cost of funding, and access to short-term uninsured market funding. - Implications for monetary transmission include: - Changing the strength of banks’ balance sheets and thereby their funding costs (stronger effect in well-developed financial systems relying more on uninsured market funding). - Hampering weaker banks’ ability to expand lending in response to monetary loosening due to high costs of raising capital. - Causing weaker banks to more sharply contract lending in response to monetary tightening. - This bank-capital version of the bank lending channel differs from older textbook variants: - Older variant 1 (Bernanke and Blinder (1988)) based on money-multiplier theory assumes reserve reductions force deposit reductions and thus lending falls—a chain of causality and behavioral assumptions that are problematic and often contradicted by observed bank behavior. - Older variant 2 assumes banks respond to reserve supply reductions by replacing reservable deposits with non-reservable liabilities (relying on depositor shifts under regulatory constraints like regulation Q); even here the causal chain operates through interest rates rather than a pure stock-of-reserves channel. - With banks able to set deposit rates freely, they tend to respond to monetary tightening by increasing deposit rates rather than passively suffering deposit loss. ### The Exchange Rate Channel - The exchange rate channel’s strength depends on: - the direct link between monetary policy and the exchange rate; and - the degree of pass-through from the exchange rate to inflation and the wider economy. - Even in small, open low- and middle-income countries where exchange rate pass-through may be strong, the direct link between policy and the exchange rate can be weak if interest-rate-sensitive cross-border capital flows are limited. - Interest-rate-sensitive cross-border capital flows are fairly limited in many LLMICs, not only in countries with closed capital accounts; thus the exchange rate channel may be weaker than assumed in these countries. - In highly dollarized economies with sizable foreign currency deposits in the local banking system, monetary policy that raises rates on local currency deposits relative to foreign currency deposits—and induces depositors to shift into local currency—can strongly affect the exchange rate. *Source: wpiea2020026-print-pdf - Introduction* ### References ### wpiea2020026-print-pdf - References ### Monetary policy implementation, operating procedures, and central bank operations - Batten, D., M. 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