Anthony Byett

1
Money and Monetary Policy Interest Rates Exchange
Rates

• Anthony Byett
• Economist
• fxmatters.co.nz
• November 2006

2
Money and Banking

• Definition of money
• NZ banking system
• Money in NZ

3
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

Refer Callander 2nd Ed p360
4
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
5
Functions of MoneyWhy hold money?

• 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

Refer Callander 2nd Ed p533
6
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

7
Banking in NZInstitutions

• Government gt collects taxes borrows money
• gt buys goods services, pays benefits
• Reserve Bank gt banker to Government banks
• gt supervises registered banks
• gt implements monetary policy
• gt issues currency
• DMO gt Governments Treasury
• Registered banks gt accept deposits/makes loans
• gt manage pooled investments
• gt process transactions
• Other financial institutions

8
M3 Financial InstitutionsOwners, assets (b) and
SP 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

9
Balance Sheets of Banks

• Assets Liabilities
• Loans - Deposits
• Reserves - Capital
• (or liquids)
• NB deposit is
• customers asset, and
• bank's liability (as owed customer)

Refer Callander 2nd Ed p535
10
NZ M3 Balance Sheet

• ASSETS (Mar-99 total143b) 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

11
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
• Source www.rbnz.govt.nz or RBNZ Financial
  Statistics

12
Monetary Aggregates
M3
M1
M2

• Move from narrow to broad definition of money
• as per The Economist, Financial Indicators

13
Definitions of Money Supply

• LIABILITIES (billion at Mar-99)
• 2 billion
• NZD 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
• Source www.rbnz.govt.nz or RBNZ Financial
  Statistics

14
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

15
Financial Assets and LiquidityMoney just one
asset
Liquidity the ease with which an asset can be
converted into an M1 asset (i.e. money ) without
loss of capital value

• Spectrum of liquidity (See Callander, p536)
• Cash Physical/human
  assets
• NB liquidity may incur opportunity costs

16
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

17
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)

Refer Callander 2nd Ed p535
18
Initial Goldsmiths Balance Sheet
Assets Liabilities
Gold Reserves 100 Deposits 100

See Callander, Fig A.2, p538, Balance Sheet A
19
Goldsmiths Balance Sheet after Lending
Assets Liabilities
Gold Reserves 100 Loans 400 Deposits 500

Reserves 20 of deposits
Compare Callander, Fig A.2, p538, Balance Sheet B
20
Fractional Reserve Banking

• A banker holds only a fraction of the outstanding
  deposits in reserve funds
• In New Zealand
• up to mid 1980s a system of compulsory reserve
  ratios operated (Reserve Ratio)
• Prudential reserve ratios are used today

21
Banking pre-80s
Assets Liabilities
Loans Reserves of Govt. Securities Deposits Capital

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

22
Banking Today
Assets Liabilities
Loans Liquids Deposits Capital

• Self-imposed liquidity management
• includes government, bank corporate securities
• Minimum capital ratios by regulation

23
Money Creationmore deposits gtgtgt more lending
Assets Liabilities
Loans Liquids Deposits Capital

• Often associated with government spending
• Govt spends money that it does not have
• Banks will on-lend (or repay other funding)

24
Money Creationmore lending gtgtgt more deposits
Assets Liabilities
Loans Liquids Deposits Capital

• 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

25
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

26
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 _at_ 0.25 over cash target
• or 0.30 if rolling intra-day bank bill repo

Refer Callander 2nd Ed p473
27
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)

28
Does Money Matter?

• Remember week 6 and GDP
• The quantity equation
• MV 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 gt more output and/or more inflation

Refer Sherwin, Inflation, Economic Alert,
Apr-99
29
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

Refer Callander 2nd Ed p420, Fig 20.6
30
Money and Inflation
31
Money and House Prices
32
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

33
Monetary Policy
34
Monetary Policy Process

• NZ monetary policy a three step process
• An inflation target is set by the Reserve Bank
  Governor (Bollard) Treasurer (Cullen)
• An inflation forecast is formed by the RBNZ
• The RBNZ adjusts short-term interest rates to
  bring the forecast into line with the target
• via cash rate target

35
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 govt control, competitive economy,
  floating exchange rate

36
Inflation
37
RBNZ Act 1989 Part II

• 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 Governors
  office
• RBNZ actions to be consistent with policy target
• RBNZ to consult advise Govt (and others)
• Governor-General can set another objective for 12
  month periods
• Policy statements every 6 months

38
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 gt0.25 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)

39
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

40
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

41
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

42
RBNZ Transmission Path Diagram
Fig 27.3, p490
43
Current Monetary PolicyRBNZ Jun-06 Projections

• 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

44
No imminent change expected
45
Monetary Theory and PracticeGeneral

• 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

46
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.

47
Interest Rates

• Many interest rates
• primary secondary markets
• wholesale retail (say lt1m)
• 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, govt stock notes are traded

48
90 Day Bank Bill
49
Retail Floating Rates
50
Retail Floating Ratesand Wholesale Rates
51
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

52
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/(1rate90/365)
• e.g. rate6.0 implies value 492,710

53
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

54
Fixed Lending Rates
55
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

56
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

57
Wholesale Yield Curve
58
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

59
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
60
NZ Inflation
61
NZ Inflation Interest Rates
62
OCR and Other Rates
63
Offshore Local Interest Rates
64
Long-term Interest Rates
65
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!

66
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

67
The equilibrium interest rateBringing together
savings and investment
Refer How low can they go? The Economist,
2-Dec-95
68
The equilibrium interest rateA model of the
current account deficit
69
Interest RatesDemand supply of bonds

• 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

70
Bond Supply Curve
71
Bond Demand Curve
72
The Equilibrium Interest RateBringing together
bond supply and money demand
73
The Equilibrium Interest RateBalancing 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

74
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

75
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

76
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/

77
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

78
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
• NZs 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

79
Exchange rates
80
Currency newsletter

• For those with an interest in currency markets
• What would you like to read in a weekly currency
  newsletter?
• Email anthony.byett_at_fxmatters.co.nz
• See www.fxmatters.co.nz

81
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

82
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

83
Exchange ratesand interest rates
84
Exchange ratesand inflation
85
Exchange ratesand the current account
86
NZ dollarNZD/AUD interest rate differential
87
NZ dollarLarge influence of AUD
88
Other currenciesversus the US dollar
89
US dollar
90
Australian dollarFollowing commodity prices
91
Australian dollarOr is it?
92
CurrencySupply and demand
Refer Callander 2nd Ed p340
93
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