How Central Banks Set the Base Rate of Interest - Essay Example

Global Financial Markets How Central Banks set base rate of interest Monetary stability pertains to low inflation and a stable currency. Stableprices are defined by the government's inflation target. The Central Bank applies various monetary policy options in order to respond appropriately at each stage of the change in the existing macro-economic environment. The country's Central Bank seeks to meet the inflation target by implementing monetary policy decisions on interest rates. Interest rates affect spending and saving in the local economy. It also has a major effect on the prices of various commodities and services. Low inflation is a positive scenario as it enables a country to maintain a stable economy and keep the value of local currency money. For example, if a Central Bank wants to attain and keep exchange rate stability and stem capital outflow, the bank must implement a high interest rate policy such as increasing call market rates to a range of 20 to 30% from a regular level of 10% in most cases. A stable foreign exchange rate will prevent a deep contraction of domestic economic activity. The Central Bank can also encourage an expansion of bank lending to small and medium enterprises by expanding its credit facility to support local enterprises. By achieving its primordial goals of stablility and efficiency in the monetary and financial frameworks, the Central Bank makes its very important contribution to the growth of the local economy. The Central Bank sets a base rate at which it transacts with other financial institutions. This interest rate then impacts on an array of interest rates set by commercial banks and building societies for their clients consisting of both borrowers and lenders. It also affects the price of financial assets including bonds and shares. The policy of decreasing or raising interest rates influences the level of spending in the economy. For instance, lower interest rates makes saving less attractive and borrowing more attractive. Lower interest rates can affect the consumers' and the firms' cash-flow. For example, a steep drop in interest rates reduces the income from savings and the interest payments due on loans. Borrowers also spend more of any extra money they have. The final effect of lower interest rates is to encourage higher spending in aggregate. Lower interest rates can boost the prices of other assets such as houses. Higher house prices permit the home owners to extend their mortgages to finance higher consumption. Higher share prices increase the households' wealth also. In addition, the main macroeconomic objectives of long-term growth and employment are achieved by monetary authorities through the judicious application of the appropriate monetary policy. Over the years, monetary authorities are focused on price stability by setting numerical targets for inflation over specific periods. As a strategic move to set the base rates, the monetary authorities make a series of choices regarding the information used as the basis for short-term and longer-term monetary policy adjustments by giving weight and specific roles to crucial economic variables. This information is applied in setting the base rate for interest rates, the prevailing foreign exchange rate regime, the intermediate money supply targets, the preferred forecasting mechanisms and the prevailing indices of the prevailing conditions in the monetary sphere. Individual country assessments on the base rate vary in most respects. The financial variables which exert an important role at the strategic level include important targets such as money, credit and asset prices. The main operating procedures which relate to the tactical level of policy implementation encompass the choice both of instruments and of operating objectives. The central bankers use major policy instruments such as official interest rates, market operations such as repurchase tenders, reserve requirements and specific direct controls like ceilings on loans and ceilings on bank deposits and loan rates. The inter-related choices pertaining to operating objectives has been on the appropriate weights which are attached to bank reserves and short-term money market rates. The operating procedures focus on the daily implementation of monetary policy. However, the planning duration can extend for one month and longer depending on the given case. (Borio and McCauley, 1) The central banks implement monetary policy through market-oriented instruments which have a significant impact on short-term interest rates as operating aims. The monetary authorities determine the conditions that equilibrate supply and demand in the market for bank reserves. This is the main source of the central banks' power to impact economic activity effectively. The central bank can directly affect demand. It does so by setting reserve requirements and influencing the operation of major interbank settlement systems. (Gup, 10) Foreign exchange markets based on monetary policy The world's market economies are faced with a wide array of foreign exchange rate and monetary regimes. The choice of a monetary policy regime comes with a given opportunity cost. Some areas of monetary flexibility are lost by making this particular decision. Hence, there is serious need to apply a consistent macroeconomic policy throughout so as to maintain economic stability. This search for a new foreign exchange rate regime by growing economies stems from a strong and recurrent preference for fixed exchange rates by most developing countries. A country's capability of setting the right foreign exchange rate contributes to economic stability and growth. Many developing countries have shifted away from fixed exchange rates and applied flexible exchange rates. Developing countries prefer to adopt flexible foreign exchange rates to take into account the shifting market demand for their currencies. In many ways, the adoption of flexible foreign exchange rates can act as shock absorbers but are less attractive to foreign investors. In other cases, flexible exchange rates can have a profound impact on the economy through balance sheet effects. In general, fixed exchange rates inspire investor confidence for as long as all the investors are convinced that the rates are sustainable and the real economy is robust and flexible enough to adjust to a series of unanticipated external shocks. The Asian post-crisis foreign exchange rate regimes evolved for long period before stability was achieved. Regimes must produce policy consistency as this is a conditio sine qua non for macroeconomic stability. For instance, given a fixed exchange rate, the decision to give up monetary policy as a way to shape domestic economic activity should be regarded as unchanging. Policy actions that impact on these constraints have resulted in weakening sustainable regimes. The Central Bank policymakers also need to take into account the country's political environment in setting the foreign exchange rate regime. Most countries have allowed increased flexibility of exchange rates and the major challenge is to craft monetary policy states that provide a strong anchor on which the market participants can base their daily decisions. (De Brouwer, p. 169) Two conditions exist in order for reserve requirements to be the binding factor in determining the (marginal) demand for reserves. One, the reserve requirement holdings must be able to reach settlement needs. Two, the amount of reserves which banks need to hold to fulfill the ideal reserve requirement should exceed their prevailing working-balance targets. In most cases, these conditions are not obtained on those days when the reserve requirements need a specific amount of reserves to be attained. In addition, the reserve requirements with averaging provisions will need lesser direct management intervention of liquidity by the central bank. This policy action depends on the level of reserves, on the duration of the averaging period and on the banks' ability to arbitrage expected changes in the overnight rate over time. The averaging is a possible source of instability in the demand for reserves, particularly volatile expectations of the path of the overnight rate during the maintenance period. Given the characteristics of the demand for bank reserves, the central bank's task is to regulate supply in order to achieve its interest rate or quantitative objectives. There are essentially two aspects to this task. The first is how to go about adjusting the liquidity position of the system, balancing supply with demand or liquidity management. The second is how to reinforce any influence that liquidity adjustments may have on interest rates through specific communication strategies via market participants through the enforcement of specific signalling mechanisms. For example, the implementation of a quasi-pegged exchange rates and high domestic interest rates were responsible for the encouraging pre-crisis capital flows to Asia. The monetary policy inconsistency focused on a fixed foreign exchange rate and the setting monetary of policy independent from that of the peg currency. The foreign investors were encouraged to finance investments by a mix of low foreign-currency interest rates and an exchange rate guarantee. Investors obtain foreign currency at cheap rates, then change it into local currency and finally invest the money in high-yielding instruments. The investor then received the spread between the local yield and the foreign borrowing cost. The investors were guaranteed a reliable return of investment since the proceeds of the investment are utilized to repay the foreign debt at the initial exchange rate. As a response to these attractive incentives, private capital flocked into East Asia in the 1990s. This paved the way for the Asian currency crisis. (De Brouwer, 170) The differences between international banking and domestic banking International banks have a bigger capital outlay, a wider international branch network, a multi-cultural bank staff and hold an international banking franchise compared to domestic banks. International banks lends to multinational corporations, government agencies and governments rather than to private individuals. International banks also focus on the development of banking relationships. International banks also adopt stricter and more prudential standards and risk diversification. International banks have advantages over domestic banks. International banks have global and regional networks. The banks' global presence offers a direct link to local businesses which undergo trade with other countries. International banks undergo innovative banking solutions that have resulted in local adaptation of banking products and practices. These banks value constant training of personnel. The bank serves the industry in this way as the local staff is hired by domestic banks to head their operations. These banks adopt global practices which become reference points for local regulators in developing regulatory norms. These banks undertake community activities such as establishing literacy campaigns. International banks rely on careful client segmentation and high technology applications for banking on its retail network. For example, BNP offers a range of products including leasing and factoring. The bank's international trade division can intervene in Africa through both the commodities and the export finance departments. The bank also offers specialized equity investment banking division for Asia and the Middle East in a variety of services, spanning from public offerings to privatizations. (De Giorgio, 5) For example, in the Middle East, many international banks operate in those countries to help foster economic development. Kuwait has opened up its banking industry to non-Kuwaiti banks in order to improve the level of services offered in the country. These international banks include National Bank of Abu Dhabi, HSBC Bank Middle East and BNP Paribas. Local banks will be forced to respond to the competition. (Ford, 1) Domestic banks cater to companies, institutions and private individuals in the local market. These banks also obtain a banking franchise from the government in the country where they operate. The bank relies on local bank staff members who are both knowledgeable and comfortable with the local culture. Hence, they maximize their knowledge of the local setting in getting new accounts. These banks frequently lend to small and medium scale entrepreneurs who can get credit only if micro-finance ventures are created. (Gup, 28) Domestic banks are also very competitive in the banking industry. These banks constantly aim to really maintain their market leadership in the industry. These banks utilize up-to-date technology to support their business strategies. These banks are customer-focused and customer-specific in its transactions. The bank staff members are adept and constant in managing customer relationships and maximizing cross-selling opportunities. They apply an automated method of monitoring sales campaign responses, keeping track of the sales data, and targeting sales campaigns to specific customer segments. This strategy enabled them to attain high sales goals and achieve profit objectives. These domestic banks have the ability to analyze data to acquire, develop and retain customers, assess the performance of different marketing campaigns, and satisfy the customers' evolving needs with the products and services. The organizational structure at domestic bank branches is lean. There is a Bank Manager, a sales team and a service team. The Bank Manager reports directly to the Board of Directors and the key officers of the bank. The sales team, led by the Relationship Manager, handles the marketing and managing of the portfolio of preferred customers. The service team serves by processing counter transactions. This well-established practice has improved the performance of the domestic banks. In a sense, the domestic banks gain deeper insights into customer behavior which allows them to develop more creative, aggressive and effective marketing campaigns. Moreover, the stronger relationships with its customers garnered these banks an enviable reputation as institutions that paid attention to individual needs. Domestic banks possess a technology-based sales, service and contact center, a well-handled customer base, and a strong local support network. Domestic banks also provide a multi-currency term loan to large domestic corporations in cooperation with an international bank. These partnerships with international banks enable these banks to develop new products that will attract the high net worth customers. However, the greater bulk of the banking services which are provided by the domestic banks focus on providing credit and depository services to local companies and individuals. The domestic banks focus on supporting the economic growth and development of the local community by providing cash management services and trustee services. (Gup, 68) References De Brouwer, Gordon. Financial Markets and Policies in East Asia.London: Routledge, 2002. Borio, CEV and Robert N. McCauley. "Comparing Monetary Policy Operating Procedures in Indonesia, Korea, Malaysia and Thailand". Ed. Gordon De Brouwer, Financial Markets and Policies in East Asia. London: Routledge, 2002. De Giorgio, Emmanuelle. Foreign vs Indigenous Banks, African Business, issue 242, April 1999, page number 18. Ford, Neil. International Banks Target Middle East: Increasing Numbers of International Banks Are Moving into Commercial and Banking Operations in the Middle East Region, Taking Advantage of New Liberalisation Laws. The Middle East. Issue: 359, August-September 2005, page number 46. Gup, Benton. The Future of Banking. Westport, CT: Quorum Books, 2003. Read More