China s Interest Rate Challenge

The Real Interest Rate Risk

This is intended to stimulate private spending by bringing down the rate of interest at which banks lend to their customers.

First, the Fed is trying to give relatively specific guidance about the future path of the federal funds rate (the overnight rate at which commercial banks lend to each other).

So, if the PBOC sets the interest rate on one year deposits at 3 , commercial banks can offer depositors a rate as high as 3.3 .

The second adverse effect of deflation is to raise the real interest rate, that is, the difference between the nominal interest rate and the rate of inflation.

America s Interest Rate Puzzle

Nevertheless, until 2011, the Selic remained at levels that were incompatible with the economy s clear strengths and low risks.

Since the interest rate set by the ECB is now less than 1 , there is little difference between its current monetary policy and what the Bank of Spain would do if it could set its own interest rate. But when the euro zone starts to recover, the ECB might choose to raise the interest rate before a higher rate would be appropriate for Spain, which could exacerbate Spanish unemployment.

Lower interest rates are not a solution to this dilemma.

And it is the real interest rate not the money rate that counts for economic growth.

At present, the interest rate is less than 0.5 .

Current low interest rates do not cover the risk that banks would take. To be sure, they could raise the rate for new and small borrowers but, in the current political climate, they would stand accused of stifling economic recovery if they did.

If credit expands too rapidly, the Fed can raise the interest rate that it pays on deposits. Sufficiently high rates will induce commercial banks to prefer the Fed s combination of liquidity, safety, and yield to expanding the quantity of private lending.

Because the inflation rate is also about 2 , this implies a negative real interest rate, which is confirmed by the interest rate of 0.6 on ten year Treasury Inflation Protected Securities (TIPS), which adjust interest and principal payments for inflation.

If the interest rate is raised too little, banks will use more reserves to support lending, leading to higher inflation. If the interest rate is raised too much, economic activity will be constrained and growth could fizzle.

However, this is no longer applied since the central bank started changing rates by 0.25 percentage points on October 19, 2010 (which was a rate increase).

But when prices are falling, the real interest rate exceeds the nominal rate.

In Japan, the ten year rate has drifted to below 0.8 .

And, due to rising consumer prices, the nominal interest rate will continue to rise.

In fact, there is no simple relationship between the size of a government s deficit or debt and the interest rate that it must pay.

In May 2006, the fairly free domestic interbank rate was just 1.62 , while the US Federal Funds rate was 5 .

According to the followers of Knut Wicksell, the central bank must keep the market rate of interest near the natural rate of interest.

But the interest rate that Greece must pay buyers of its government bonds has shot up to a record high level of nearly 9 5.9 percentage points above the benchmark rate paid by Germany.

For, even as the central banking authority administered the price of liquidity, the price of risk was left to the tender mercies of the market.

As a result, the interest rate for 12 month fixed deposits has reached 3.9 .

All the above assumes that the interest rate remains constant throughout the whole period.

Central banks respond to lowered demand by reducing interest rates and to higher expected inflation by raising interest rates.

Surplus Chinese savings made possible America s credit expansion between 2003 2005, when the federal funds rate (the overnight rate at which US banks lend to one another) was held at 1 .

In bid and ask, the bid price stands in contrast to the ask price or offer , and the difference between the two is called the bid ask spread.

But such an insignificant rate hike will do little to relieve long term pressures, because investors will expect more rate hikes and move money into China, increasing upward pressure on the yuan s exchange rate.

Domestic deflation means that the real interest rate on Japanese bonds is higher than the nominal rate.

Foreign investors then sent their money to New York to take advantage of the higher rates.

Current low interest rates do not cover the risk that banks would take.

In other words, the price of losing one year of income every 75 years instead of every 50 years would lead banks to increase the rate on a loan from 4 to 4.13 .

The first, the Secular Stagnation Hypothesis, has been proposed by Larry Summers. Its key premise is that the equilibrium interest rate at which demand would balance supply is currently below the actual interest rate.

A direct effect of the higher interest rate would be to increase the budget deficit and the rate of growth of government debt.

Past experience implies that the real rate will rise to at least 2 , taking the total nominal interest rate to more than 4 , even if expected inflation remains at just 2 .

And that is important, because a rise in the federal funds rate will cause other, somewhat longer interest rates to increase as well.

Monetary policy is now drawing on a more comprehensive toolkit, such as the policy rate, the interest rate corridor, required reserve ratios, and the reserve option mechanism.

It could have used a portion of the interest savings to recapitalize the banks.

Although it is difficult to anticipate how high long term interest rates will eventually rise, the large budget deficit and the rising level of the national debt suggest that the real rate will be higher than 2 . A higher rate of expected inflation would also cause the total nominal rate to be greater than 5 .

SMEs and households with net savings stand to gain the most from interest rate liberalization. But financial repression s winners commercial banks and SOEs will face new challenges.

Central banks should influence asset prices through normal open market operations by buying and selling short term government securities for cash, thus changing the safe interest rate and the price of longer duration assets

Under these conditions, the Fed will want to raise the interest rate to prevent an acceleration of inflation.