Central Banks Announce Coordinated Interest Rate Reductions

Throughout the current financial crisis, central banks have engaged in continuous close consultation and have cooperated in unprecedented joint actions such as the provision of liquidity to reduce strains in financial markets. Inflationary pressures have started to moderate in a number of countries, partly reflecting a marked decline in energy and other commodity prices. Inflation expectations are diminishing and remain anchored to price stability. The recent intensification of the financial crisis has augmented the downside risks to growth and thus has diminished further the upside risks to price stability.

Some easing of global monetary conditions is therefore warranted. Accordingly, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, Sveriges Riksbank, and the Swiss National Bank are today announcing reductions in policy interest rates. The Bank of Japan expresses its strong support of these policy actions.

Bank of Canada lowers overnight rate target by ½ percentage point to 2½ per cent.

The Bank of Canada today announced that it is lowering its target for the overnight rate by ½ percentage point to 2½ per cent. The operating band for the overnight rate is correspondingly lowered, and the Bank Rate is now 2¾ per cent.

The intensification of the global financial crisis is having a marked impact on all countries. In recent weeks conditions in global financial markets have deteriorated sharply, the U.S. economy has weakened further, and commodity prices have fallen abruptly.

As a result of these developments, credit conditions in Canada have tightened significantly, despite the relative health of our financial institutions. Weaker growth in the United States and other important trading partners will increase the drag on the Canadian economy coming from net exports. The deterioration of our terms of trade will act to moderate the growth of domestic demand. While the recent depreciation of the Canadian dollar will help cushion the effects of the weaker global outlook on the domestic economy, it will not completely offset them.

Below-potential growth in aggregate demand through 2009, combined with a lower profile for commodity prices, will significantly ease inflation pressures in Canada. Inflation expectations remain well anchored.

In view of these developments, the Bank of Canada decided to join other major central banks and lower its target for the overnight rate by 50 basis points today. This action will provide timely and significant support to the Canadian economy. The Bank will continue to monitor carefully economic and financial developments, along with the evolution of risks, in judging whether any further action might be required to achieve its 2 per cent inflation target over the medium term.²

So read a press release from the Bank of Canada issued on October 8, 2008. The BOC lowered the overnight rate by 0.5 percentage points in an attempt to prevent the deepening of the recession.³ What was special about this announcement was that the BOC lowered its target for the overnight rate on a date that was outside its fixed schedule of dates for policy interest rate announcements. The press release indicated that this surprise interest rate cut was part of a coordinated effort by central banks around the world that were attempting to loosen the tight financial market and to support the weakening global economy. We learned about the overnight rate in Chapter 14: it is the rate at which banks lend excess reserves to each other generally for one business day or less (unless a longer term is negotiated). The BOC sets a target for the overnight rate, and then it’s up to the BOC’s officials to achieve that target. This is done by open-market operations—buying and selling government bonds, usually short-term bonds.

Once the BOC sets the target for the overnight rate, other key interest rates, such as the prime rate, rates on GICs, and mortgage rates, will move in the same direction, and these interest rates tend to change in proportion to the change in the target for the overnight rate. How does the BOC go about achieving a target for the overnight rate? And more to the point, how is the BOC able to affect interest rates at all?

Recall that, for simplicity, we’re assuming there is only one interest rate paid on non-monetary financial assets, both in the short run and in the long run. To understand how the interest rate is determined, consider Figure 15-4, which illustrates the liquidity preference model; this model says that the interest rate is determined by the supply and demand for money in the market for money. Figure 15-4 combines the nominal money demand curve, MD, with the nominal money supply curve, MS, which shows how the nominal quantity of money supplied by the Bank of Canada varies with the interest rate. As we did with MD, from now on, we drop the word “nominal,” with the understanding that “money” in MS, as in MD, represents nominal quantities.

In Chapter 14 we learned how the Bank of Canada can increase or decrease the money supply: it usually does this through open-market operations, buying or selling Canadian government bonds (in practice, short-term treasury bills), but it can also lend via the bank rate or pursue government deposit switching. Let’s assume for simplicity that the BOC, using one or more of these methods, simply chooses the level of the money supply that it believes will achieve its interest rate target. Then the money supply curve is a vertical line, MS in Figure 15-4, with a horizontal intercept corresponding to the money supply chosen by the BOC, . The money market equilibrium is at E, where MS and MD cross. At this point the quantity of money demanded equals the money supply, , leading to an equilibrium interest rate of i_E.

To understand why i_E is the equilibrium interest rate, consider what happens if the money market is at a point like L, where the interest rate, i_L, is below i_E. At i_L the public wants to hold the quantity of money M_L, an amount larger than the actual money supply, . This means that at point L, the public wants to shift some of its wealth out of interest-bearing assets such as GICs into money.

This has two implications. One is that the quantity of money demanded is more than the quantity of money supplied. The other is that the quantity of interest-bearing money assets demanded is less than the quantity supplied. So those trying to sell non-money assets such as issuers of bonds will find that they have to offer a higher interest rate to attract buyers. As a result, the interest rate will be driven up from i_L until the public wants to hold the quantity of money that is actually available, . That is, the interest rate will rise until it is equal to i_E.

Now consider what happens if the money market is at a point such as H in Figure 15-4, where the interest rate i_H is above i_E. In that case the quantity of money demanded, M_H, is less than the quantity of money supplied, . Correspondingly, the quantity of interest-bearing non-money assets demanded is greater than the quantity supplied. Those trying to sell interest-bearing non-money assets will find that they can offer a lower interest rate and still find willing buyers. This leads to a fall in the interest rate from i_H. It falls until the public wants to hold the quantity of money that is actually available, . Again, the interest rate will end up at i_E.

You might have noticed that this is the second time we have discussed the determination of the interest rate. In Chapter 10 we studied the loanable funds model of the interest rate; according to that model, the interest rate is determined by the equalization of the supply of funds from lenders and the demand for funds by borrowers in the market for loanable funds. But here we have described a seemingly different model in which the interest rate is determined by the equalization of the supply and demand for money in the money market. Which of these models is correct?

The answer is both. We explain how the models are consistent with each other in Appendix 15A. For now, let’s put the loanable funds model to one side and concentrate on the liquidity preference model of the interest rate. The most important insight from this model is that it shows us how monetary policy—actions by the Bank of Canada and other central banks—works.

Let’s examine how the Bank of Canada can use changes in the money supply to change the interest rate. Figure 15-5 shows what happens when the BOC increases the money supply from to . The economy is originally in equilibrium at E₁, with an equilibrium interest rate of i₁ and money supply . An increase in the money supply by the BOC to shifts the money supply curve to the right, from MS₁ to MS₂, and leads to a fall in the equilibrium interest rate to i₂. Why? Because i₂ is the only interest rate at which the public is willing to hold the quantity of money actually supplied, .

So an increase in the money supply drives the interest rate down. Similarly, a reduction in the money supply drives the interest rate up. By adjusting the money supply up or down, the BOC can set the interest rate.

In practice, the Governing Council of the Bank of Canada decides at each meeting what interest rate should prevail until the next fixed announcement date of the target for the overnight rate. The BOC sets a target for the overnight rate, which is the desired level for the overnight rate. The BOC then adjusts the money supply by buying and selling treasury bills until the overnight rate reaches the target rate. The BOC can use other tools to reach the target rate, such as monetary policy implemented via government deposit switching, foreign exchange market intervention, and buying and selling of other assets, but these tools are used only rarely.⁴

Figure 15-6 shows how this works. In both panels, i_T is the target for the overnight rate. In panel (a), the initial money supply curve is MS₁ with money supply , and the equilibrium interest rate, i₁, is above the target rate. To lower the interest rate to i_T, the BOC makes an open-market purchase of treasury bills. As we learned in Chapter 14, an open-market purchase of treasury bills leads to an increase in the money supply via the money multiplier. This is illustrated in panel (a) by the rightward shift of the money supply curve from MS₁ to MS₂ and an increase in the money supply to . This drives the equilibrium interest rate down to the target rate, i_T.

Panel (b) shows the opposite case. Again, the initial money supply curve is MS₁ with money supply . But this time the equilibrium interest rate, i₁, is below the overnight rate, i_T. In this case, the BOC will make an open-market sale of treasury bills, leading to a fall in the money supply to via the money multiplier. The money supply curve shifts leftward from MS₁ to MS₂, driving the equilibrium interest rate up to the target for the overnight rate, i_T.

Earlier in this chapter we mentioned that long-term interest rates—rates on bonds or loans that mature in several years—don’t necessarily move with short-term interest rates. How is that possible, and what does it say about monetary policy?

Consider the case of Millie, who has already decided to place $10 000 in Canadian government bonds for the next two years. However, she hasn’t decided whether to put the money in one-year bonds, at a 4% rate of interest, or two-year bonds, at a 5% rate of interest. If she buys the one-year bond, then in one year, Millie will receive the $10 000 she paid for the bond (the principal) plus interest earned. If instead she buys the two-year bond, Millie will have to wait until the end of the second year to receive her principal and her interest.

You might think that the two-year bonds are a clearly better deal—but they may not be. Suppose that Millie expects the rate of interest on one-year bonds to rise sharply next year. If she puts her funds in one-year bonds this year, she will be able to reinvest the money at a much higher rate next year. And this could give her a two-year rate of return that is higher than if she put her funds into the two-year bonds today. For example, if the rate of interest on one-year bonds rises from 4% this year to 8% next year, putting her funds in a one-year bond today and in another one-year bond a year from now will give her an annual rate of return over the next two years of about 6%, better than the 5% rate on two-year bonds.

The same considerations apply to all investors deciding between short-term and long-term bonds. If they expect short-term interest rates to rise, investors may buy short-term bonds even if long-term bonds bought today offer a higher interest rate today. If they expect short-term interest rates to fall, investors may buy long-term bonds even if short-term bonds bought today offer a higher interest rate today.

As this example suggests, long-term interest rates largely reflect the average expectation in the market about what’s going to happen to short-term rates in the future. When long-term rates are higher than short-term rates, as they were in 2010, the market is signalling that it expects short-term rates to rise in the future.

This is not, however, the whole story: risk is also a factor. Return to the example of Millie, deciding whether to buy one-year or two-year bonds. Suppose that there is some chance she will need to cash in her investment after just one year—say, to meet an emergency medical bill. If she buys two-year bonds, she would have to sell those bonds to meet the unexpected expense. But what price will she get for those bonds? It depends on what has happened to interest rates in the rest of the economy. As we learned in Chapter 10, bond prices and interest rates move in opposite directions: if interest rates rise, bond prices fall, and vice versa.

This means that Millie will face extra risk if she buys two-year rather than one-year bonds, because if a year from now bond prices fall and she must sell her bonds in order to raise cash, she will lose money on the bonds. Owing to this risk factor, long-term interest rates are, on average, higher than short-term rates in order to compensate long-term bond purchasers for the higher risk they face (although this relationship is reversed when short-term rates are unusually high).

As we will see later in this chapter, the fact that long-term rates don’t necessarily move with short-term rates is sometimes an important consideration for monetary policy.