Central Bank Role

This blog follows directly from “Deficit Spending 101 – Part 3”.

The central bank operations aim to manage the liquidity in the  banking system such that short-term interest rates match the official  targets which define the current monetary policy stance. In achieving  this aim the central bank may:

(a) Intervene into the interbank money  market (e.g. the Federal funds market in the US) to manage the  daily supply of and demand for funds; (b) buy certain financial assets  at discounted rates from commercial banks; and (c) impose penal lending  rates on banks who require urgent funds, In practice, most of the  liquidity management is achieved through (a). That being said, central  bank operations function to offset operating factors in the system by  altering the composition of reserves, cash, and securities, and do not  alter net financial assets of the non- government sectors.

Money markets are where commercial banks (and other intermediaries)  trade short-term financial instruments between themselves in order to  meet reserve requirements or otherwise gain funds for commercial  purposes. In terms of the diagram [as seen in the previous blog] all these transactions are horizontal  and net to zero.

Commercial banks maintain accounts with the central bank which permit  reserves to be managed and also the clearing system to operate  smoothly. In addition to setting a lending rate (discount rate), the  central bank also sets a support rate which is paid on commercial bank  reserves held by the central bank. Many countries (such as Australia,  Canada and zones such as the European Monetary Union) maintain a default  return on surplus reserve accounts (for example, the Reserve Bank of  Australia pays a default return equal to 25 basis points less than the  overnight rate on surplus Exchange Settlement accounts). Other countries  like Japan do not offer a return on reserves which means persistent  excess liquidity will drive the short-term interest rate to zero (as in  Japan until mid 2006) unless the government sells bonds (or raises  taxes). This support rate becomes the interest-rate floor for the  economy.

The short-run or operational target interest rate, which represents  the current monetary policy stance, is set by the central bank between  the discount and support rate. This effectively creates a corridor or a  spread within which the short-term interest rates can fluctuate with  liquidity variability. It is this spread that the central bank manages  in its daily operations.

In most nations, commercial banks by law have to maintain positive  reserve balances at the central bank, accumulated over some specified  period. At the end of each day commercial banks have to appraise the  status of their reserve accounts. Those that are in deficit can borrow  the required funds from the central bank at the discount rate.  Alternatively banks with excess reserves are faced with earning the  support rate which is below the current market rate of interest on  overnight funds if they do nothing. Clearly it is profitable for banks  with excess funds to lend to banks with deficits at market rates.  Competition between banks with excess reserves for custom puts downward  pressure on the short-term interest rate (overnight funds rate) and  depending on the state of overall liquidity may drive the interbank rate  down below the operational target interest rate. When the system is in  surplus overall this competition would drive the rate down to the  support rate.

The demand for short-term funds in the money market is a negative  function of the interbank interest rate since at a higher rate less  banks are willing to borrow some of their expected shortages from other  banks, compared to risk that at the end of the day they will have to  borrow money from the central bank to cover any mistaken expectations of  their reserve position.

The main instrument of this liquidity management is through open  market operations, that is, buying and selling government debt. When the  competitive pressures in the overnight funds market drives the  interbank rate below the desired target rate, the central bank drains  liquidity by selling government debt. This open market intervention  therefore will result in a higher value for the overnight rate.  Importantly, we characterise the debt-issuance as a monetary policy  operation designed to provide interest-rate maintenance.  This is in  stark contrast to orthodox theory which asserts that debt-issuance is an  aspect of fiscal policy and is required to finance deficit spending.

The significant point for this discussion which we build on next is  to expose the myth of crowding out is that net government spending  (deficits) which is not taken into account by the central bank in its  liquidity decision, will manifest as excess reserves (cash supplies) in  the clearing balances (bank reserves) of the commercial banks at the  central bank.  We call this a system-wide surplus. In these  circumstances, the commercial banks will be faced with earning the lower  support rate return on surplus reserve funds if they do not seek  profitable trades with other banks, who may be deficient of reserve  funds. The ensuing competition to offload the excess reserves puts  downward pressure on the overnight rate. However, because these are  horizontal transactions and necessarily net to zero, the interbank  trading cannot clear the system-wide surplus. Accordingly, if the  central bank desires to maintain the current target overnight rate, then  it must drain this surplus liquidity by selling government debt, a  vertical transaction.

Bill Mitchell

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