Anthony Byett Economist fxmatters.co.nz November 2006 Money and Monetary Policy Interest Rates Exchange Rates

Anthony ByettEconomist

fxmatters.co.nz

November 2006

Money and Monetary Policy

Interest Rates

Exchange Rates

Money and Banking

Definition of money

NZ banking system

Money in NZ

ReviewIntroducing a stock into the flow model

Money is a stock concept

– measured at a point in time Income is a flow concept

– per annum concept

Households FirmsGoods & services

produced from

capital & labour

Refer Callander2nd Ed p360

Forms of Money

Utu, favour exchange

Gold, greenstone, cigarettes

Notes & coins

Transaction accounts– access by cheque, EFT-POS, telephone

Savings accounts– NB some accessible by ATM, telephone

Debit cards (as opposed to credit cards)

Refer:* The Economist 22-Dec-01 pp85-87

Medium of exchange. In order to function it must have the following properties:

- acceptable - scarce- portable - divisible - durable

Store of value

Unit of account

Means of deferred payment

Functions of MoneyWhy hold money?

Refer Callander 2nd Ed p533

Money in NZHow much?

Recent figures put money = $171 billion– I.e. Jun-06 “M3 money supply” reported by RB

– including $2.8 billion notes & coins

– remainder were bank deposits

Had been $93b in Mar-99– breakdown of this figure to come in following

slides

Banking in NZInstitutions

Government > collects taxes & borrows money > buys goods & services, pays

benefits

Reserve Bank > banker to Government & banks > supervises registered banks

> implements monetary policy

> issues currency

DMO > Government’s Treasury

Registered banks > accept deposits/makes loans

> manage pooled investments

> process transactions

Other financial institutions

M3 Financial InstitutionsOwners, assets ($b) and S&P credit ratings

1 ANZ National ANZ, Aus 87 AA-2 WestpacTrust* Westpac, Aus 48 AA-3 BNZ NAB, Aus 46 AA-4 ASB Bank CBA, Aus 42 AA-5 Hong Kong* HK Shanghai 6 AA-6 Deutsche Bank* DB, Germany 6 AA-TSB NZ trust 3 BBB- Others (3 banks/sub & 2 non-bank)13 TOTAL (at Dec-05) 251

* Branches

Note: Kiwibank ($2.5b) is a bank but not within M3 survey (yet)

Source: www.rbnz.govt.nz and www.kpmg.co.nz

Balance Sheets of Banks

Assets Liabilities

+ Loans - Deposits

+ Reserves - Capital

(or liquids)

NB: deposit is– customer’s asset, and

– bank's liability (as owed customer)


NZ “M3” Balance SheetASSETS (Mar-99 total=$143b) $b

NZD claims (lending) 122

Non-NZD claims 5

NZ Government securities 7

Claims on RBNZ/notes & coins 1

Other assets 9

LIABILITIES

NZD funding (deposits) 100

Non-NZD funding 28

Capital 8

Other liabilities 7

Source: www.rbnz.govt.nz or RBNZ Financial Statistics

Definitions of money supply

LIABILITIES ($billion at Mar-99)

NZD funding (deposits) 100

Transaction accounts (net*) 12

Other call accounts (net) 27

Other deposits (net) 52

* the netting involves the deduction of inter-institutional deposits and government deposits


Monetary Aggregates

Move from narrow to broad definition of money

– as per The Economist, Financial Indicators

M3M1 M2

LIABILITIES ($billion at Mar-99)

$2 billionNZD funding (deposits) 100 notes & coins

held by public

Transaction accounts (net) +12 14 = M1

Other call accounts (net) +27 41 = M2

Other deposits (net) +52 93 = M3


Definitions of Money Supply

Money SupplyNote that …….

Unexercised overdrafts– not part of money supply

Debit cards and cheques– not themselves money

Credit cards– accumulate debt to be settled with M1 money

Financial Assets and Liquidity

Money just one asset

Spectrum of liquidity (See Callander, p536)

Cash Physical/human assets

NB liquidity may incur opportunity costs

Liquiditythe ease with which an asset can be converted into an M1 asset (i.e. money ) without loss of capital value

Money Creation

The creation process– bank asset & liability

growth

Limits on natural growth– Daily settlement

– Government does not create money

– Government flows offset

Money and inflation

Money and growth

Where Does Money Come From?

Primitive Bankers– acted as custodians

– issued receipts for gold deposits

– receipts used for transaction purposes

Banking Evolved – bankers made loans (for interest) by issuing

more receipts

– assumed not all holders of deposits would want gold at the same time

reserves only needed to be a fraction of their deposits (liabilities)


Initial Goldsmith’s Balance Sheet

Assets $ Liabilities$

Gold Reserves100

Deposits 100

See Callander, Fig A.2, p538, Balance Sheet A

Goldsmith’s Balance Sheet after Lending


Gold Reserves100

Loans 400

Deposits 500

Compare Callander, Fig A.2, p538, Balance Sheet B

Reserves = 20% of deposits

Fractional Reserve Banking

A banker holds only a fraction of the outstanding deposits in reserve funds

In New Zealand– up to mid 1980’s a system of compulsory

reserve ratios operated (Reserve Ratio)

– ‘Prudential reserve ratios’ are used today

Banking pre-80s

Regulated Reserve Ratios– only replaced in the mid-1980s


Loans

Reserves of Govt. Securities

Deposits

Capital

Banking Today

Self-imposed liquidity management– includes government, bank & corporate

securities

Minimum capital ratios by regulation


Loans

Liquids

Deposits

Capital


Loans

Liquids

Deposits

Capital

Money Creationmore deposits >>> more lending

Often associated with government spending– Gov’t spends money that it does not have

Banks will on-lend (or repay other funding)


Loans

Liquids

Deposits

Capital

Money Creationmore lending >>> more deposits

More likely the cause today– A bank lends money during day (which it may not

have)

– Loan money is deposited in bank

– Loan becomes “self-funding”

Managing Money Growth in NZ

Government issues debt to fund any revenue shortfall (I.e. does not create money)

– Long-term: Government Stock issued monthly (approx.)

– Short-term: Treasury Bills issued weekly

RBNZ also smoothes daily government flows

– through daily and now intra-day settlement

– through open market operations

The Settlement Process

Settlement banks bank with the RBNZ– non-settlement banks bank with settlement banks

At end of day*, the net daily inter-bank flows are known (* next morning actually)

– money owed to other banks paid with RBNZ balances

– i.e. settlement cash

– if bank has no “cash” – tries to borrow from other bank

– can borrow from RBNZ @ 0.25% over cash target

– or +0.30% if rolling intra-day bank bill repo


Smoothing Settlement Cash

RBNZ conduct daily “open market operations” (OMO) to smooth flows

– largely to offset government flows

Too much cash forecast RBNZ sells T-Bills for cash

Not enough cash forecast RBNZ lends cash

– banks borrow cash using Bills and Bonds as security

– actually sell bills/bonds and forward purchase (repo)

Does Money Matter?

Remember week 6 and GDP…

The quantity equationMV = PY

M= stock of money ($)

P= price level ($)

V= velocity of circulation (times per year)

Y= volume of production (number of “things”)

if velocity steady, money growth will match nominal production growth

more money > more output and/or more inflation

Refer:* Sherwin, “Inflation”, Economic Alert, Apr-99

The Output GapLinking money to AD/AS model

More “money” leads to greater aggregate demand

We cannot satisfy all this demand with new products/services

Feeds through to higher prices

AS

Price Level

Real Output

AD AD1

Inflation

Refer Callander2nd Ed p420, Fig 20.6

Money and Inflation

Money and House Prices

-10%

0%

10%

20%

30%

Mar-94 Mar-97 Mar-00 Mar-03 Mar-06

6

9

12

15

18

Source: QVNZ, RBNZ, ASB

Change NZ house price

(left)

Change M3 lending to households (right)

%HOUSE PRICES & HOUSEHOLD DEBT

Summary

Money typically is bank deposits

Can be created from thin air

Growth constrained by capital requirements

– and source of funding

– And by government financing with debt

Also volatility reduced by RBNZ cashflow smoothing

Some loose connection between money and inflation/growth exists

Monetary Policy

Monetary Policy Process

NZ monetary policy a three step process:

1. An inflation target is set by the Reserve Bank Governor (Bollard) & Treasurer (Cullen)

2. An inflation forecast is formed by the RBNZ

3. The RBNZ adjusts short-term interest rates to bring the forecast into line with the target

» via cash rate target

Inflation

In theory, inflation a momentum– the ongoing rise of prices, wages, money supply

In practice, inflation is the change in CPI– goods & services that households consume

– weighted according to proportion of spending

Inflation high late 70s, low now– vicious cycle: higher wages, prices & devaluations

– tried to contain with wage/price freeze early 80s

– eventually moved to independent Reserve Bank

– also tight gov’t control, competitive economy, floating exchange rate

Inflation

“The primary function of the Bank is to formulate and implement monetary policy directed to the economic objective of achieving and maintaining stability in the general level of prices”

Inflation target set for term of Governor’s office

RBNZ actions to be consistent with policy target

RBNZ to consult & advise Gov’t (and others)

Governor-General can set another objective for 12 month periods

Policy statements every 6 months

RBNZ Act 1989 Part II

The Inflation Target

Contract between RBNZ Governor and Treasurer

– Governor appointed to September 2007 Stability agreed to as CPI inflation between 1-3% p.a. on

average over the medium term

Exceptions allowed (if >0.25 was rule of thumb):

– terms of trade shock

– changes to indirect taxes

– natural disaster shock

– changes to government levies

(see Policy Targets Agreement, September 2002)

Consumer Price IndexAs at June 2006

Annual rate 4.0%

– Large contributions from housing & petrol

But inflation?– To what extent

will rises be ongoing?

Tradable vs Non-tradable Inflation

-2

0

2

4

6

Mar-92 Mar-95 Mar-98 Mar-01 Mar-04

-2

0

2

4

6

Tradables

Non-tradables

NZ CPI INFLATION %%

The inflation forecast

RBNZ forecasts inflation

look at annual CPI forecast out 24 months

in RBNZ model, inflation determined by:– exchange rate movements

– international price of exports & imports

– unit labour costs

– output gap

– inflation expectations

influential factors are TWI & unit labour costs

Implementation of Policy

If forecast inflation does not match the target

– then some policy response is required

Policy signalled via interest and exchange rate forecasts

Policy acts through short-term interest rates

Policy is implemented through the official cash rate target

– from 17 March 1999

RBNZ Transmission Path Diagram

Fig 27.3, p490

Forecast annual CPI of 3.9% p.a. (falling to 2.4%)

Cash rate unchanged on the day (7¼%)

Assumes growth slowing

– GDP Mar 04/05 +3.5% to 06/07 +1.1%

“Growth to remain low … headline CPI inflation above 3% well into 2007 … do not expect to tighten … no scope for easing of the OCR this year”

Source: www.rbnz.govt.nz

Current Monetary PolicyRBNZ Jun-06 Projections

No imminent change expected

6.4

6.6

6.8

7.0

7.2

7.4

7.6

Today Dec-06 J un-07 Dec-07

%

As at 21-Aug

Source: ASB

ANTICIPATED 90-DAY BANK BILL (as priced by futures)

Monetary Theory and Practice

General Theory links money growth with

inflation

Correlation between money and nominal output exists in long-run (Quantity equation again)– in short-run, relationship is not evident

Chronic and acute inflation has been associated with money-financed government budget deficits

Monetary Theory and PracticeNZ experience

NZ Government debt-finances

Money growth plays small role

Early 90s fall in inflation coincided with international recession and fiscal tightening

There exist long and uncertain lags between changes to monetary conditions and inflation

Large changes in interest rates are needed to change exchange rates & inflation rates– Low elasticity with respect to interest rates.

Interest Rates

Many interest rates– primary & secondary markets

– wholesale & retail (say <$1m)

Short-term yields (or rates) set in money market where cash, bills and notes are traded

Long-term yields (or rates) set in bond market where bonds, gov’t stock & notes are

traded

90 Day Bank Bill

0

4

8

12

16

20

74 78 82 86 90 94 98 02

NZ 90-DAY BANK BILL(at year end)

Source: ASB Bank

%

Retail Floating Rates

4

6

8

10

12

J an-93 J an-96 J an-99 J an-02 J an-05

4

6

8

10

12

RETAIL FLOATING RATES

Source: ASB

% %

Top Deposit(0-12 months)

Housing

Retail Floating Ratesand Wholesale Rates

4

6

8

10

12


4

6

8

10

12

FLOATING RATES

Source: ASB

% %

TD(0-12 mths)

ASB Housing

90-day bill

A 90-day bank billwhat is it?

A “bank bill” in NZ now is typically a certificate stating the bank will pay a fixed sum (the face value) to the holder at a set date

– in essence, a tradeable bank deposit

– called a Negotiable Certificate of Deposit (NCD)

More traditionally (and still traded today) a “bank bill” was a Bank Accepted Bill (BAB)

– two parties set up a loan which a bank then endorses

– bank guarantees payment in case of default

A 90-day Bank Billsome characteristics

Returning to Negotiable Certificate of Deposit

– typically issued by banks for 30-180 days

– e.g. bank will pay holder $0.5m in 90-days

– holder can sell to another party if they wish

– banks initially receive market value

Market value of bill determined by bill rate

– NB the rate is a discount rate

– Value = 500,000/(1+rate*90/365)

– e.g. rate=6.0% implies value =$492,710

Major Money Market Instruments

Name Issuer

Treasury Bills Government

Promissory Notes Corporates

Bank Bills Banks

Derivatives linked to Bank Bills:– Futures, Forward Rate Agreements (FRAs)– Options– Interest rate swaps

Fixed Lending Rates

5

6

7

8

9

10

11

12


5

6

7

8

9

10

11

123 YEAR RATES

Source: ASB

% %

ASB Housing

Major Market Instruments

Securities promising the holder a defined cashflow– Bill (short term)

– e.g. pay $100,000 to holder on 10-Aug-2005– no coupon or interest rate

– Bond (long term) – includes coupon rate as well– e.g. pay $100,000 to holder on 15-5-2010 plus

$3,000 on the 15th of each May & Oct– can get zero coupon bonds

Major Bond Market Instruments

Name Issuer

Government Stock Government

Medium Term Note Corporates/Banks

Bond Corporates/Banks

Derivatives linked to Government Stock:– futures (3yr only)

– options

Wholesale Yield Curve

4

5

6

7

8

9

10

0 30 60 90 120 150 180 270 1 2 3 4 5

31/12/97

31/12/99

<< Days >< Years >>

The Yield CurveDiffering theories

Segmented markets– different people operate in different markets

– rates loosely connected

Expectations– longer-term rates as series of expected short-

term rates

Liquidity or risk premium– premium required to induce people to hold

longer-term investment

Element of all in NZ, strong expectation influence

Interest RatesInfluences

Inflation ( real rate)

Monetary policy

Offshore interest rates

Exchange rate expectations

Extent of borrowing

Next:

– some graphical evidence– some theory

Refer National Bank, Sep 1996

NZ Inflation

0

5

10

15

20

74 78 82 86 90 94 98 02

0

5

10

15

20

NZ CPI INFLATION

Source: Stats NZ, ASB Bank

% %

NZ Inflation & Interest Rates

0

4

8

12

16

20

74 78 82 86 90 94 98 02

0

4

8

12

16

20

NZ INFLATION & 90-DAY BANK BILL

Source: ASB Bank

%

Year End 90-day

%

Year EndCPI

OCR and Other Rates

NZ SHORT-TERM RATES (July 1999 to August 2006)

4

5

6

7

8

9

10

J ul-99 J ul-01 J ul-03 J un-05

4

5

6

7

8

9

10

%

ASB Variable Home Loan

90-day bank bill

Offshore & Local Interest Rates

0

2

4

6

8

10

12

J an-93 J an-96 J an-99 J an-02 J an-05 J an-08

0

2

4

6

8

10

12

90-DAY BANK BILL YIELDS(actual and futures pricing)

% %

NZ

AUS

Long-term Interest Rates

3

4

5

6

7

8

9

10

11


3

4

5

6

7

8

9

10

11

10YR GOVERNMENT YIELDS% %

NZ

AUS

Interest ratesTheories

Interest rates as a price reflecting decisions about flows

savings = investment

Interest rates as a price reflecting decisions about stocks (I.e. a portfolio decision)

demand for bonds = supply of bonds

These decision processes may be independent!

Interest ratesSavings & investment

People require a positive return to save– i.e. give up current consumption for future

consumption

– savings are expected to rise should rates rise

People willing to pay now to invest– i.e. pay funding cost now in expectation of future

return

– the higher the return, the higher the interest rate

– clouded by ‘return-insensitive investment’

– e.g. government investment

Interest rate a balance of productivity & time preference

The equilibrium interest rateBringing together savings and investment

Interest rate

Amount of savings/investment

Savings

Investment

Refer “How low can they go?” The Economist, 2-Dec-95

The equilibrium interest rateA model of the current account deficit

Interest rate

Amount of savings/investment

Savings

InvestmentRate set low

BOP deficit

Motives for holding bonds– spare cash not needed for transaction

purposes

– as a store of wealth in general

Bond supply– Corporates issues to get cash for investment

– either into physical assets or financial assets

Interest rate a balance of demand and supply for bonds

Interest RatesDemand & supply of bonds

Bond Supply Curve

SUPPLY (borrowers)

Rate of interest

Bond Stock

Bond Demand Curve

DEMAND (lenders)

Rate of interest

Bond Stock

The Equilibrium Interest Rate

Bringing together bond supply and money demand

SUPPLY

Rate of interest

Bond Stock

DEMAND

r

The Equilibrium Interest Rate

Balancing portfolio decisions

Bonds are just one financial asset

Interest rates are also set in other markets– e.g. money market

In general, returns are established in many financial markets

– e.g. share markets

“interest rates” are the result of portfolio decisions

Summary

Interest rates result from the interaction of many decisions

– both about production/saving

– and about asset allocation

In the short-run, RBNZ policy is the major determinant of short-term rates

– longer-term, savings and investment issues will be more influential

Long-term rates are strongly influenced by offshore rates

Banking References

“The banking system in NZ”, Chris Moore, Economic Alert, May 1996

“NZ banks ...”, David Tripe, Massey University, quarterly

Chapter 9 in “Structure & dynamics of NZ industries”, Pickford & Bollard, Dunmore Press, 1988

Chapter in Overview of NZ Economy, NZDMO, see www.treasury.govt.nz/nzefo

“Liberalisation of the financial markets in NZ”, Arthur Grimes, RBNZ Bulletin, December 1998

“Developments in the banking industry”, RBNZ Bulletin, Each June quarter

“Consolidated table of KIS”, RBNZ Bulletin, June 1997

Banking Web Sites

http:// www.rbnz.govt.nz/

http:// www.asbbank.co.nz/

http:// www.anz.co.nz/

http:// www.bnz.co.nz/

http:// www.westpac.co.nz/

http:// www.nationalbank.co.nz/

http://centre-banking-studies.massey.ac.nz/

http://www.kpmg.co.nz/

http://www.bis.org/

Monetary Policy References

Various RBNZ publications– see www.rbnz.govt.nz

Critics of monetary policy– “Prosperity denied”, Bob Jones, Canterbury

University Press, 1996

– Chapter 7 in “The NZ experiment”, Jane Kelsey, Auckland University Press, 1995

Interest Rate Referencesgeneral

“Interest rates and money markets in Australia”, Tom Valentine, Financial Training & Analysis Services, 1991

“The Reuters guide to official interest rates”, Ferris & Jones, Probus Publishing, 1995

“NZ’s money revolution”, Edna Carew, Allen & Unwin, 1987

Reserve Bank Bulletins incl. “An overview of the money and bond markets in NZ”, Sep & Dec 1995.

Some more websites

bloomberg.com

yahoo.com

dismal.com

worldeconomist.com

thepaperboy.com

yardeni.com

imf.org

stats.govt.nz

treasury.govt.nz

Exchange rates

Currency newsletter

For those with an interest in currency markets …

What would you like to read in a weekly currency newsletter?

Email: [email protected]

See www.fxmatters.co.nz

Exchange rate determinantsSome generalisations

in the short-run, high interest rates will lead to a strong currency

in the medium term, large current account deficits will lead to depreciations

in time, low inflation rates will lead to an appreciating currency

Exchange rate volatility

rates are more volatile than fundamentals

fundamentals matter in the long run

– but not in short run

herding as a response to uncertainty

– Refer A Kirman, Bank of England Bulletin, Aug 95

Exchange ratesand interest rates

-1

0

1

2

3

4

5

93 95 96 98 00 02

0.35

0.45

0.55

0.65

0.75

INTEREST RATE DIFFERENCE & NZ DOLLAR

Source: ASB Bank

% USD

NZ-US 90day (left)

USDper NZD(right)

Exchange ratesand inflation

30

50

70

90

110

74 78 82 86 90 94 98 02

0.4

0.6

0.8

1.0

1.2

1.4

US/NZ INFLATION & NZ DOLLAR

Source: ASB Bank

%

Year End NZD(rhs)

USD

US Prices per NZ Prices (lhs)

Exchange ratesand the current account

-16

-12

-8

-4

0

74 78 82 86 90 94 98 02

0.4

0.7

0.9

1.2

1.4

CURRENT ACCOUNT & NZ DOLLARCurrent Account as a % of GDP, NZD/USD at year end

Source: ASB Bank

%

NZD(rhs)

Rate

BOP (lhs)

NZ dollarNZD/AUD & interest rate differential

65

70

75

80

85

90

95

91 93 95 97 99 01 03

-3

-2

-1

0

1

2

3

NZD/AUD & 90-DAY RATES

Source: ASB Bank

cents

NZD/AUD

%

NZ 90-dayless

AUS 90-day

NZ dollarLarge influence of AUD

NZD & AUD

0.45

0.55

0.65

0.75

0.85

93 95 96 98 00 02

0.35

0.45

0.55

0.65

0.75

Source: ASB Bank

USD USD

USD per AUD

USD per NZD

Other currenciesversus the US dollar

EXCHANGE RATE INDICES (versus USD, relative to average 1993-2003 = 100)

60

80

100

120

140

93 95 97 99 01 03

Source: ASB Bank

J PY

NZD

AUD

EUR

US dollar

80

90

100

110

120

130

140

150

70 74 78 82 86 90 94 98 02

-6

-4

-2

0

US DOLLAR & US BOP

Source: ASB Bank

Index

USD Index(left)

%GDP

BOP (right)

Australian dollarFollowing commodity prices

AUD/USD & COMMODITY PRICES, 1983 to 2002

0.45

0.5

0.55

0.6

0.65

0.7

0.75

0.8

0.85

0.9

0.95

Dec-83 Dec-85 Dec-87 Dec-89 Dec-91 Dec-93 Dec-95 Dec-97 Dec-99 Nov-01

75

80

85

90

95

100

105

110

115

AUD/USD, lhs

CBA Commodity Price Index, rhs

USD INDEX

Australian dollarOr is it?

AUD & CBA AUSTRALIANCOMMODITY PRICE INDEX

60

70

80

90

100

110

120

130

94 95 96 97 98 99 00 01 02 03 04

0.48

0.55

0.62

0.70

0.77

0.85

0.92

0.99

USD

AUD/USD (rhs)

CBA AUSIndex in USD

(lhs)

Sources: CBA, Datastream

USD Index1997=100

NZD AND COMMONWEALTH BANKNZ COMMODITY PRICE INDEX

80

85

90

95

100

105

110

115

120

94 95 96 97 98 99 00 01 02 03 04

0.39

0.43

0.47

0.51

0.55

0.59

0.63

0.67

0.71

USD

NZD/USD(right)

USD Index(left)

Sources: CBA, Datastream

Index1997=100

Index in USD compared with end

of week NZD/USD exchange rate

CurrencySupply and demand

USDPer

NZD

Amount of currency

Supply

Demand


Summary

Exchange rates result from the interaction of many decisions

– both about trading goods and services

– and about investing in assets

In the short-run, interest rates are often the key determinant

– longer-term, any trade imbalance will impact

In NZ, the AUD is a large influence

Documents

Anthony Byett Economist fxmatters.co.nz November 2006 Money and Monetary Policy Interest Rates Exchange Rates