In Britain, there is no M3. The broad money measure is called M4. It consists of M0 plus sterling deposits held at British banks by the non-bank private sector.
Velocity of circulation
Velocity of circulation, that is, the number of times money changes hands in a year, may be measured by nominal GDP divided by any monetary aggregate such as M2 averaged over the year.
Deposit creation and monetary growth
Commercial banks create money. They can lend out a large proportion of deposits placed with them, since it is unlikely that all customers will ask for their money back at once.
Suppose a bank receives a new $100 deposit and lends $80 of it. By the stroke of a pen the bank creates a loan (debit balance $80) and a new deposit (credit balance $80). Even if the customer withdraws the entire $80 to pay for some consumer goods, the retailer is likely to redeposit the $80, probably in a different bank. The second bank has a new deposit of which it might lend $60. This credit creation will gradually peter out, but not until one new deposit has created loans (= deposits = money) of several times its own size.
Reserve assets
For prudence and monetary control central banks limit the proportion of new deposits which banks can on-lend by requiring them to hold a fixed proportion of their assets in the following.
High-powered reserves. Cash (till money) and balances at the central banks (operational deposits) which are used to meet day-to-day requirements for customer withdrawals and interbank settlements.
Secondary reserves. “Safe” liquid assets such as Treasury bills which can be used to meet temporary increases in withdrawals.
Monetary control
Monetary authorities attempt to control the size and growth of money in several ways.
Changing reserve-asset ratios. This affects the multiple which banks can lend and is usually done only once every few years.
Open-market operations. Buying or selling government bonds in the open market, which increases or reduces the amount of money in bank reserves and private deposits.
Influencing interest rates. For example, by means of open-market operations (which affects the supply and demand for money), changing the discount rate (see page 182), or imposing fixed rates for certain deposits or loans.
Credit controls. For example, limits on total bank lending, total personal credit, or the margins that borrowers have to put up for any credit purchase.
Moral suasion. For example, central banks hold heart-to-heart talks with commercial bankers, perhaps to persuade them to restrict lending.
Note that direct control over reserve-asset ratios and the monetary base affects the supply of money while the other measures affect demand for it.
Alternative indicators of monetary growth
Monetary growth can be tracked by watching the deposits which are included in the various monetary aggregates. Alternative approaches are to track the following.
The banking sector’s balance sheet. Movements on the liabilities side (deposits) must be matched by movements in assets (mainly loans) and liabilities not included in monetary aggregates.
Sectoral counterparts. These are measured by money the public sector takes out of circulation (roughly, the budget surplus plus government bond sales to non-banks) plus net additions by the banking sector (mainly bank lending) plus net additions from overseas (net balance of payments inflows to the private sector).
Monetary targets
Monetary authorities adopt many approaches to monetary control. During the 1980s and for much of the 1990s, many central banks (in Britain, the Treasury) had explicit targets for chosen monetary aggregates.
This has largely fallen out of favour. Several central banks, including the Federal Reserve, the European Central Bank, the Bank of England and the Reserve Bank of New Zealand, now have targets or desired target ranges for inflation instead. Monetary growth is one of several indicators of economic activity that central bankers watch.
Although the European Central Bank targets inflation rather than monetary growth, it has a “reference value”, reiterated in December 2002, of 4.5% for the annual rate of growth of M3. It thinks that this is the rate consistent with its inflation target (that consumer prices should rise by less than 2% per year), a trend rate of GDP growth of 2–2.5% and an annual decline of 0.5–1% in the velocity of circulation of M3.
Interpretation
An important reason for the decline in the importance of monetary targets is Goodhart’s law, named after an economist who sat on the Bank of England’s monetary policy committee, which sets British interest rates. The law says that any monetary variable loses its usefulness within six months of being adopted as a target of monetary policy.
The problem is that if relative interest rates or other influences change, investors quickly move their balances from deposits with one institution (which might be included in a particular definition of money) to another (which might not). This can cause the Ms to jump up and down at different rates and make interpretation tricky. Other complications include international capital flows and changes in the velocity of circulation.
Watch for cash lurking in the sidelines and changes in domestic and international relative interest rates and yields, and for factors which might distort some or all monetary aggregates.
Even though monetary targets no longer enjoy the primacy they once did, central bankers and economists still watch monetary aggregates closely. In interpreting them, the difficulties mentioned in the previous paragraph should be borne in mind. Remember also that although many monetary measures are seasonally adjusted, it is advisable to be on the lookout for erratic influences. It is also wise to take several months together and compare with the same period a year earlier.
Table 12.1 Money supply
In general, if a monetary aggregate is growing too rapidly (faster than its target rate, or faster than is consistent with the central bank’s inflation target), this may be an argument for the central bank to raise interest rates. Slow monetary growth is a sign of weakening economic activity, and may be an argument for lower rates. However, other signals of inflationary pressures will also be taken into account.
Bank lending, advances, credit, consumer credit
Measures: Loans to persons, companies and the public sector.
Significance: Indicator of monetary conditions.
Presented as: Monthly totals.
Focus on: Trends.
Yardstick: Roughly, growth should equal target for monetary aggregates.
Released: Monthly; one month in arrears.
Overview
Changes in overall bank lending figures indicate the effectiveness of monetary policy. Changes in lending to various sectors may indicate trends in various parts of the economy.
Personal and consumer credit
Net new borrowing by households finances the purchase of homes and consumer goods and services. Such borrowing tends to be sensitive to interest rates and consumer confidence. It is translated directly into higher spending (see also Retail sales, House sales, Motor vehicle sales, Consumer expenditure), output and imports.
Growth in household credit is generally good when demand is slack, but it can be inflationary when demand is already buoyant. Excessive borrowing to finance the acquisition of other financial assets such as shares is also worrying: it may help to drive up their prices, making consumers feel wealthier and ready for a bout of inflationary spending.
Borrowing by companies
Companies borrow to finance their operations, investment and takeovers. Corporate borrowing generally slackens when the economy is booming and funds are generated by buoyant sales. On the other hand, there will be more investment activity when companies are most optimistic (see Business conditions, page 115).
A breakdown by industry will reveal trends in various industrial sectors. High borrowing may reflect either optimism and investment or recession and debts. Output, orders and capacity utilisation figures will indicate which.
Central bank policy rates
Measures: Interest rates at which central banks lend to banking systems.
Significance: Indicator of central banks’ monetary policy; influences banks reserves, monetary growth and market interest rates.
Presented as: Annual percentage rate.
Focus on: Rate, trends.
Yardstick: See Table 12.2.
Released: Changed daily, fixed weekly, or moved only at irregular intervals.
Table 12.2 Comparative interest rates
Overview
Within the constraints of market pressures, central banks manage their banking systems to keep liquidity and short-term interest rates at or near to officially desired levels. Central banks:
intervene in the interbank money market to manage the daily balance of supply and demand;
often publish formal discount rates at which they provide money to commercial banks to help smooth longer (say, weekly) financing needs; and
occasionally impose penal rates for emergency lending to banks.
Central banks aim to influence monetary conditions by setting the interest rates on which they are willing to lend money to commercial banks. These rates in turn influence the rates at which banks deal with each other and their customers, and hence affect economic activity as a whole. In America, the Federal Reserve aims to control the Federal funds rate. The Bank of Japan works on the overnight call money rate.
For European central banks, such as the European Central Bank, the Bank of England and the Swedish Riksbank, the principal instrument of monetary policy is called the repo rate (or, at the ECB, the refinancing or “refi” rate). A repo is a sale and repurchase agreement where one financial dealer sells securities to another with an agreement to buy them back at a given price on a certain date. In effect, in setting its repo rate the central bank is announcing the terms on which it will provide a short-term loan (say a week) to banks, in return for which the banks pledge securities as collateral. The repo rate is the interest rate on this loan, expressed in annual terms.
Policy rates are usually set at regular meetings of central banks. America’s Federal Open Market Committee meets eight times a year. The Bank of England’s monetary policy committee and the European Central Bank’s governing council meet monthly. Some central banks, including the Fed, Bank of England and the Riksbank, publish the minutes of their meetings a few weeks after they take place. These are watched keenly by economists, as they contain clues to central bankers’ thinking – such as, for example, the economic indicators they consider most important. In addition, central banks publish regular economic assessments. In Britain, the Bank of England issues an Inflation Report in February, May, August and November, which summarises developments over the previous three months and contains projections of inflation and GDP growth for up to two years ahead.
Interest rates; short-term and money-market rates
Measures: Interest charged on financial paper with maturity up to 12 months.
Significance: Indicator of monetary conditions, expectations, credit worthiness.
Presented as: Annual percentage rates (see also discount rates above).
Focus on: 3-month interbank (or CD/Treasury bill rate if no interbank rate).
Yardstick: See Tables 12.2 and 12.4.
Released: Almost continuously round the clock.
Overview
Money markets are the markets in which banks and other intermediaries trade in short-term financial instruments.
The hub is usually the interbank market (called the Federal funds market in America), which is where banks deal with each other to meet their reserve requirements (see Money supply, page 175) and, longer-term, to finance loans and investments.
Very short-term interbank interest rates are largely determined by central bank intervention (see page 181), although market pressures are also influential. For other maturities and other financial instruments, relative maturities and credit risks are also important.
Maturity
Loans in the short-term market range from call (repayable on demand) and overnight to 12-month money. Interest rates on 12-month paper are higher than on shorter maturities if market participants expect interest rates to rise, or lower if rates are expected to fall. Supply and demand imbalances can cause temporary interest rate bulges at various maturities. It is not unknown for overnight money rates to top 100% on rare occasions. Use three-month rates as the benchmark.
Credit risk
Treasury bills (loans to the government) are regarded as completely safe in the major industrial countries and command the finest (lowest) interest rates, usually below interbank rates. Interest rates are higher on certificates of deposit (CDs – bank deposits which can be sold) and, usually, higher still on corporate or commercial paper (loans to companies).
LIBOR and variants
Interbank rates are quoted bid (to borrow) and offer (to lend). The London interbank offered rate (LIBOR) is a benchmark. The interest rates on many credit agreements worldwide are set in relation to it; for example, as LIBOR plus 0.5%. With the creation of the euro, EURIBOR, a euro-equivalent, has come into being.
12.1 Short-term interest rates
Source: OECD
12.2 Short-term interest rates, 2008
Source: OECD
There is no direct equivalent in America. Its interbank market is the Federal funds market, while the base for loan contracts is the prime rate (the rate charged to borrowers with prime or excellent creditworthiness). However, whereas LIBOR changes constantly under the direct influence of supply and demand, the prime rate is set by the banks (with reference to market rates) and is changed less regularly.
Two technical points
Interest and discount
Note the difference between interest rates (investment yields) and discount rates. Treasury bills and commercial paper are issued at a discount to their maturity value. A 12-month bill with a face value of $100 might be sold for $92.50, when the discount is $7.50:
the discount rate is 7.5% (7.50 divided by 100 as a percentage);
the interest rate is 8.1% (7.50 divided by 92.50 as a percentage).
Basis points
Dealers sometimes talk about basis points, where 100 basis points = 1% (percentage point) or 1 basis point = 0.01%.
Interest rates and the economic cycle
Whether by government action or by constraints of supply and demand, interest rates tend to rise when economic activity is buoyant and fall when it is slack.
Lower interest rates encourage borrowing, which leads to more consumer spending and investment, increased imports, a higher level of economic activity and possibly faster inflation. Higher interest rates do the opposite. The problem for finance ministers and central bankers is getting the timing right. It can take perhaps 12–18 months for the full effect of a change in interest rates to feed through.
Interest rates and currencies
Changes in interest rates affect the relative attractiveness of holding a currency (see Exchange rates, page 154). For example, an increase in American interest rates will encourage a shift into the dollar, pushing it up and making American imports cheaper and European imports dearer. Other countries which want to maintain exchange-rate relationships or prevent money-market outflows are forced to raise their interest rates as well.
Bond yields
Measures: Interest return on fixed-interest securities.
Significance: Indicator of interest and inflation expectations, credit worthiness.
Presented as: Annual percentage rates.
Focus on: Long-dated government bonds.
Yardstick: See Table 12.3.
Released: Almost continuously round the clock.
Table 12.3 Benchmark yields
Overview
Bonds are loans with fixed regular coupons (interest payments) and usually a fixed redemption value on a given date. Some bonds are perpetual or undated loans which are never repaid or are repaid only at the borrower’s option.
The yield (effective rate of interest) on bonds is determined by market conditions. Investors in bonds want to be compensated for loss of interest on other instruments, the time and credit risk of holding bonds and expected inflation. Risks are minimised with government bonds (loans to the government) and unlike shares the maturity value is fixed, so the yield on long-dated government bonds may be taken as an indicator of expected trends in interest rates and inflation.
British government bonds are known as gilts, or gilt-edged securities, after the paper on which they were once printed.
Yield calculations
Bonds are traded in secondary markets at prices which in a mechanical sense reflect their redemption value, coupon, credit rating and other interest rates.
For example, a closely watched American Treasury (government) bond with a 5.13% coupon repayable at $100 in 2016 was trading at just under $100 in mid-2006. In return for the $99.83 outlay, a buyer would receive $5.13 a year in coupons and $100 on maturity, making the effective investment yield, or rate of interest, 5.15% a year.
Corporate bonds with the same maturity and redemption details trade at a lower price (higher yield) reflecting the greater risk of default.
Benchmark bonds that professional in vestors watch are shown in Table 12.3. These change over time as bonds mature and new ones are issued.
Yields and prices
Note the negative relationship between bond yields and bond prices. If prices fall, interest yields increase. If prices rise, interest yields decline.
Yields and the economic cycle
Since interest rates tend to rise when economic activity is buoyant and fall when it is slack, bond prices tend to fall on the upward leg of the economic cycle and rise on the downward leg.
Index-linked issues
The British and some other governments have issued index-linked bonds, where the coupons and redemption value are linked to consumer prices. The yield on such bonds is the real interest rate.
Guide to Economic Indicators Page 16