We know that if gaps open between the demand and supply of reserves, interbank interest rates will be subject to volatile movements. Question. How can the central bank keep an interest rate on a fixed target? Central banks operate by setting an operational target for the interbank rate. The central bank tries to keep the market interbank rate very near this target on a day to day basis. The target is reinforced to the policy rate. The policy rate is a repo interest rate set for regular lending and borrowing by the central bank. These operations are conducted to bring the interbank rate to the operational level. After reviewing this segment, you should be able to; one, model the regular operations used by the central bank to keep the interbank rate on the operating target. Let's get started. Consider this daily data showing the Bank of Thailand policy interest rate and overnight Bibor or the Bangkok interbank offered rate. At any point in time the central bank has a policy target of 1.5 Percent. We can see that on a day to day basis, Bibor stays within several basis points of the target. A basis point is a percent of a percent. Half a percent is 50 basis points. Overnight interest rate rarely deviate more than a few basis points from the target. On a regular scheduled, usually either daily or weekly basis. Central banks will conduct a liquidity auction, offering short term lending or short term borrowing to or from the market, and a preannounce policy rate. The auctions are operated to bring interbank lending rates in line with a policy target. This regularly liquidity operation is conducted in the repo market. The Bank of Thailand schedule's a bilateral repurchase operation at 9: 30 a.m. every day, at a rate determined by policy makers. In the case of June 2017, repo operations were conducted at a 1.5 Percent annualized rate. What if the central bank detects a liquidity shortage at the morning repo operation? Before the morning monetary operation, the central bank estimates demand for reserves at the policy rate. This is often done by directly contacting the relevant managers at the local banks. If the demand for reserves at the policy rate exceeds the extant supply, the resulting liquidity shortage will put upward pressure on the interbank rate. When the central bank detects a liquidity shortage on a given day, they buy securities using repurchase agreements. This provides immediate but temporary liquidity to commercial banks in need. Reserves are credited to the commercial bank seller and short term bonds are sold to the central bank. This is exactly the form of an open market purchase and it provides actual liquidity to the interbank market. Since this is done with a repurchase agreement, the liquidity is temporary and affect loan to the market by the central bank. Arbitrage keeps the interbank rate near the policy rate. If there are many banks short of liquidity, then the interbank rate may be relatively high. If a bank has a shortage of liquidity and the policy rate is below the interbank rate, then they prefer to get liquidity from the official repo operation rather than borrowing in the interbank market. This reduces the number of banks borrowing in the interbank market, which will in turn bring the interbank rate downward toward the repo rate. When the central bank provides as much liquidity as banks want at the policy rate, the liquidity will shift out sufficiently to fill the liquidity shortage. This will equalize supply and demand at the policy rate. The interbank rate will be in equilibrium near the policy rate. Banks frequently change their decision to lend reserves or hold them, based on conditions in the economy or financial markets. Given frequent autonomous fluctuations in reserve demand, either the central bank will match demand fluctuations with equal supply adjustments or allow frequent swings in interbank interest rates. Suppose the banks decide increase their inventory of reserve for precautionary transactions purposes, this will reduce the amount of excess reserves they're able to lend in the interbank market. The lesser availability of reserves induces a shortage of liquidity in the interbank market putting upward pressure on interbank rates. This leads the central bank to engage in a defensive liquidity operation, filling demand for liquidity through repurchase agreements at the repo rate. The additional liquidity stabilizes interest rates to the target. If the central bank estimates that the existing liquidity exceeds reserve demand at the current policy rate, they must drain liquidity to avoid downward pressure on the interbank rate. If the supply of reserves exceeds the demand for reserves at the policy rate, the resulting liquidity surplus would put downward pressure on the interbank rate. In an operation to drain liquidity, the central bank acts as a seller of securities, selling a quantity of government securities to commercial banks. On a near date, reserves are debited from the account of the counter-party. This immediately drains reserve liquidity as in an open market sale, and liquidity is reduced immediately. The central bank simultaneously contracts to buy securities from the counter-party bank. At some future date plus interest, so the reduction in reserves is temporary. On the far date, the bonds are repurchased by the central bank. So the liquidity drain is temporary. So in essence, the central bank drains liquidity from the market by simply borrowing it. If commercial banks have a surplus of reserves and the policy rate is above the interbank rate, then they would be willing to offer the central bank funds at the policy rate. This reduces the number of banks trying to lend surplus liquidity in the interbank market, which in turn will bring the interbank rate toward the policy rate. If the central bank estimates that the existing liquidity exceeds reserve demand at the policy rate, they must drain liquidity to avoid downward pressure on the interbank rate. They borrow funds at the policy rate, reducing excess liquidity, and bring the equilibrium interest rate in line with the policy rate. If there is a decline in reserve demand, this will pressure the central bank. A decline in reserve holding by banks would increase access reserves available for lending. The liquidity surplus in the interbank market puts downward pressure on interbank rates. This induces the central bank to engage in a defensive operation draining liquidity at the policy rate. Liquidity management stabilizes interest rates to the target. To see the effectiveness of regular liquidity operations, examine the case of China. Prior to 2015, short term interbank rates in the form of the Shanghai interbank offered rate were extremely volatile. That year the central bank began regular repo operations at a fixed policy rate called the reverse repurchase rate. Operations occur first twice a week then on a daily basis. These operations are effective in keeping the SHIBOR rate near the target. Now that we've completed the segment, you should be able to one: model the regular operations used by the central bank to keep the interbank rate on the operating target. As we wrap up, let's conclude by summarizing the key question; How does the central bank set a target for the interest rate? Daily repo operations are used to plug the gap between liquidity supply and demand preventing the necessity of interest rate adjustment. The central bank injects reserves through temporary liquidity operations, when they detect an increased demand for liquidity or upward pressure on this interest rate. The central bank drains liquidity through temporary liquidity operations, when they detect reduce demand for liquidity or downward pressure on interest rate.
