Policy Rate Setting Mechanisms

🏦 Bank of Zambia's Recent Monetary Policy Decision: Bank of Zambia (BoZ) has implemented a significant monetary policy change by increasing its policy rate by 50 basis points to 14.0% 📈. This decision, while facing some criticism, represents a calculated move to address persistent inflation and stabilize the Kwacha 💱. The policy action warrants a detailed examination to understand its implications and effectiveness in the current economic context. 💰 Interest rate adjustments serve as a fundamental tool in the central bank's monetary policy arsenal. The BoZ's decision to raise rates operates through several key mechanisms. Higher rates help curb inflation by reducing money supply and dampening excessive spending. Increased rates discourage unnecessary borrowing while promoting savings 🏦. The full impact of rate adjustments typically manifests over several months as economic actors adjust their behavior. Critics have questioned the effectiveness of repeated rate adjustments, but it's crucial to understand that monetary policy operates with inherent time lags ⏳. In Zambia's current economic environment, characterized by external pressures and commodity price volatility, interest rate management remains one of the most reliable tools available to the central bank. 📊 The BoZ's strategy extends beyond simple rate adjustments. The current inflationary pressures in Zambia stem from multiple sources, including currency depreciation, supply-side shocks, global economic uncertainties, and climate-related challenges such as drought affecting hydroelectric power generation ⚡. The recent policy rate increase helps anchor inflation expectations, preventing behaviors that could exacerbate price increases. Higher rates make the Kwacha more attractive to investors, potentially reducing capital outflows 📉. 💲 The Kwacha's vulnerability to external shocks has been a persistent concern. The policy rate adjustment addresses this through enhanced investment appeal, as higher rates attract both domestic and foreign investment by offering better returns 🌍. The policy helps manage capital movements and support currency stability, while clear monetary policy signals help build market confidence in the currency. ⚖️ While critics may question the repeated use of interest rate adjustments, these measures remain necessary for managing immediate inflation pressures, stabilizing the currency, protecting economic stability, and safeguarding public welfare. The policy rate increase represents a calculated step in maintaining economic stability and protecting Zambians from severe inflationary consequences 🛡️. Success depends on coordinated efforts across multiple policy areas and sustained commitment to economic reforms. objectives, while remaining responsive to both domestic and international economic developments 🌐. ©️ Natasha Lloyd

The federal funds market, which determines the interest rate the Fed targets for monetary policy, could collapse. The Fed has known for decades that a collapse of the fed funds market was a likely consequence of the giant balance sheet approach to monetary policy it is now using. Some FOMC participants want the Committee to switch from targeting the fed funds rate to targeting the repo rate. But if the FOMC targets the repo rate, the Fed will have to remain massive and entangled in financial markets. Instead, the Fed should follow the strategy recently articulated by Governor Michelle Bowman – continue to shrink until the fed funds market recovers. Because that will take time, and the fed funds market could collapse soon, the Fed may need an interim strategy, such as targeting the overnight bank funding rate; targeting the general level of money market rates; or ceasing to announce a target rate at all and simply setting and announcing its policy rates. But these alternatives should be temporary steps on a path toward a smaller Fed. In the longer term, the optimal target is a fed funds rate determined in an active market where banks redistribute reserve balances at the end of the day. The FOMC may have begun discussing their policy implementation framework at the September meeting. If so, the meeting minutes that will be released this afternoon at 2:00 pm will shed some light on their deliberations.

Monetary Policy: Intuitive approach Economy as a large house, and the central bank (like the RBI) as the thermostat controller. Its job? To keep the temperature (inflation) just right—not too hot, not too cold. Tools of the Thermostat Just like a thermostat, the central bank has knobs and settings: Repo Rate (the midpoint of the LAF corridor): ▪ Turning it up cools the economy (reduces inflation) ▪ Turning it down warms it up (stimulates demand) Liquidity Management: ▪ More liquidity = more economic activity ▪ Less liquidity = slower, more controlled pace Tools used: Absorbing liquidity with banks through SDF and providing liquidity to Banks through MSF. Repo is an anchor rate with operating rates-SDF/MSF set 25 bps (lower / higher) on either side of REPO. VRRR & VRR are auctioned. All these (SDF, VRRR, VRR, SDF) influence short term rates and short term liquidity. Open Market operations &FX swaps to manage durable liquidity & influence bond yields (long term rates). Another control lever is the CRR rate. Whether actions had a desirable impact on market rates: Call money rate is the indicator: stay near SDF when liquidity with banks is in surplus or near MSF when liquidity is tighter. Auctions / open market operations cause’s rates to move higher or lower within the corridor depending on absorption of liquidity or infusion as needed. The Objective: Comfortable Living The RBI aims to keep the economic "room" stable and liveable, targeting 4% inflation with a tolerance band of ±2%. Transmission: How the Heat Spreads Like heat through vents, policy changes take time to flow through the system: Affects bank funding costs and thereby influence loan EMIs, deposit rates, and investment appetite Changes in behaviour of households and businesses gradually align demand with supply, keeping inflation and growth on track India’s Evolving Thermostat * Monetary Targeting (till 1998): Pre-set heating—predicted how much money (M3) was needed and set it accordingly. * Multiple Indicator Approach (1998–2014): Smart sensors—RBI watched various indicators (credit, inflation, external sector) to adjust the settings. * Flexible Inflation Targeting (since 2014): Smart thermostat—actively targets inflation, while factoring in growth. O/N call rates move within the LAF corridor depending on the liquidity adjusted. Work is on to develop a broader ‘Secured overnight rate’ (Including. TREPS, market repo as call rates have lower volumes) for better alignment. Takeaway The central bank is like the climate manager of the economy. It can’t change global winds (external shocks), but by adjusting the right knobs at the right time, it keeps our economic home stable, safe, and growth friendly. Disclaimer: This analogy is a simplified representation intended to aid conceptual understanding for beginners. It does not capture all technical or institutional complexities of monetary policy frameworks. Views expressed are personal. #policy

TAYLOR RULE ANALYSIS: Why Fed Should Not Cut Rates TAYLOR's RULE Calculation: What Should Fed Rates Be? (September 2025) THE FORMULA: Taylor Rule: r = π + 0.5×y + 0.5×(π - 2%) + 2% Where: r = Target federal funds rate π = Core PCE inflation (Fed's preferred measure) y = Output gap (unemployment-based) 2% = Fed's inflation target 2% = Neutral real interest rate CURRENT DATA (Official Sources): Core PCE Inflation: 2.9% (Bureau of Economic Analysis) Unemployment Rate: 4.3% (Bureau of Labor Statistics) Natural Unemployment (NAIRU): 4.3% (Congressional Budget Office) Current Fed Funds Rate: 4.33% Step 1: Calculate Output Gap Output Gap = -2 × (4.3% - 4.3%) = 0.0% (Using Okun's Law: unemployment at natural rate = zero output gap) Step 2: Apply Taylor Rule r = 2.9% + 0.5×(0.0%) + 0.5×(2.9% - 2%) + 2% r = 2.9% + 0.0% + 0.45% + 2% r = 5.35% THE RESULT: Taylor Rule Rate: 5.35% Current Fed Funds: 4.33% WHAT THIS MEANS: The Taylor Rule suggests rates should be higher than current levels. However, this mechanical calculation represents just one analytical perspective. CONSIDERATIONS: While the Taylor Rule provides valuable guidance, Federal Reserve policymakers consider numerous additional factors: - Forward-looking labor market indicators - Financial stability conditions - Global economic uncertainties - Real-time vs. backward-looking data - Market functioning and liquidity - Asymmetric risks and policy lags KEY INSIGHTS: With unemployment (4.3%) essentially at the natural rate (4.3%), the labor market shows full employment Core inflation (2.9%) remains above the Fed's 2% target, suggesting some pricing pressures BOTTOM LINE: The Taylor Rule serves as a useful benchmark, but effective monetary policy requires judgment about economic conditions, forward-looking risks, and policy transmission mechanisms that extend far beyond any single formula. My take: Given persistently above-target core PCE inflation (2.9%) alongside GDP growth well above potential (3.3% vs. ~1.9%) and an unemployment rate hovering at its natural level (4.3% NAIRU), cutting rates now would risk entrenching price pressures and further overheat an already tight labor market. Maintaining or modestly raising policy rates would help anchor inflation expectations, preserve central bank credibility and guard against second-round effects from sustained inflation momentum. Sources: Bureau of Economic Analysis, Bureau of Labor Statistics, Congressional Budget Office, Federal Reserve Economic Data

R.B.I & REPO RATE How does RBI set the repo rate (the policy interest rate)? A key input is the Natural/Neutral Interest Rate (NIR) - which is the interest rate at which inflation neither increases nor decreases (or the interest rate at which savings equals investment). The repo rate minus inflation gives the real repo rate (RRR). And the relationship between RRR and NIR gives the monetary policy stance: 1. RRR > NIR --> Contractionary monetary policy (ie, decreases inflation) 2. RRR < NIR --> Expansionary monetary policy (ie, increases inflation) 3. RRR = NIR --> Neutral monetary policy (ie, maintains inflation) Hence NIR is a very important input in conducting monetary policy. A. What Decides NIR? NIR is decided by factors that affect the long-run savings-investment behaviour: 1. Factors that increase savings *decrease* NIR. 2. Factors that increase investment *increase* NIR. All these factors keep changing over time - hence NIR also keeps changing over time. B. How To Find Out NIR? Different mathematical models are available for estimating NIR: 1. Statistical filtering methods 2. Structural economic models a) Dynamic Stochastic General Equilibrium (DSGE) models b) Semi-structural models 3. Time series models 4. Market-based approaches a) Financial markets data b) Forward-looking measures 5. Policy rules C. Best Method The most popular method is a semi-structural model given by Thomas Laubach and John Williams in their paper "Measuring the natural rate of interest" (Review of Economics and Statistics, 2003). According to this model: r*(t) = cg(t) + z(t) Where: r*(t) = NIR c = Risk aversion parameter g(t) = Potential growth rate z(t) = Factors that affect savings-investment behaviour The model also uses: 1. IS curve (for aggregate demand) 2. Phillips curve (for inflation dynamics) D. India's NIR In 2024, RBI estimated India's NIR at 1.4%-1.9% for Jan-Mar 2024. The graph shows how India's NIR has changed from 2000 to 2024. E. Conclusion 1. NIR keeps changing over time. 2. Different models give different estimates for NIR. 3. Even the best model gives a range for the estimated NIR. 4. Hence conducting monetary policy is a very tricky exercise. Info-source: "Updating estimates of the natural rate of interest for India with post-pandemic evidence" by Harendra Kumar Behera (RBI Bulletin, July 2024) #India #Economy #Economics 

Historically, the Bangladesh Bank targeted money supply to achieve its monetary policy objectives. In doing so, it used to periodically announce certain targets for monetary aggregates such as the reserve money, M2, private-sector credit etc and tried to achieve those targets. Nudged by the IMF, the Bangladesh Bank is now transitioning to interest-rate targeting. Under the new approach, the policy interest rates will be the Bangladesh Bank’s primary monetary policy tools. Therefore, the policy interest rates must be well-calibrated and changes in them should affect the overall interest rates, asset prices, exchange rates, inflation, the level of employment, and output. For this transmission mechanism to work, the Bangladesh Bank needs to ensure that the short-term, risk-free interest rates, such as the yields of 3-month T Bills, remain in the vicinity of the policy rates. Then the market-determined credit spreads will be added to these rates to determine the other short-term interest rates and market expectations about future short-term interest rates will determine the long-term interest rates. For this to happen, the Bangladesh Bank must print money when the short-term, risk-free interest rates are higher than the policy rates and shrink its balance sheet or de-print money when the short-term, risk-free rates are lower than the policy rates. In other words, to successfully adopt interest-rate targeting, the Bangladesh Bank needs to be flexible with regard to money supply parameters. That requires a change in the mindsets of the central bankers, economic analysts and financial reporters who are used to dealing with the growths, or the lack thereof, with respect to the reserve money, M2, private sector credit etc.

NBE new monetary policy framework 1. NBE is moving to an interest-rate based monetary policy regime. The NBR will be used to signal policy stance and influence broader monetary and credit conditions. 2. Setting the initial policy interest rate at 15 percent. This rate reflects current economic conditions, such as declining inflation and low base money growth. 3. Bi-weekly monetary policy auctions. Open Market Operations (OMO) will be conducted every two weeks to manage liquidity, ensuring interbank market rates stay close to the NBR. 4. Introducing Overnight Lending and Deposit Facilities. These facilities will help banks manage daily liquidity at the NBR rate plus or minus 3 percent. 5. Launching an electronic interbank money market platform. This platform will facilitate continuous lending and borrowing among banks, promoting a functional interbank money market. 6. Retaining past liquidity management tools during the transition. Quantitative measures for monetary management may be used as supplementary tools, and specific instruments for interest-free banking providers will be specified soon.

What does CBSL’s Single Policy Rate Mean for Banks and Financial Institutions ? The Central Bank of Sri Lanka’s move to adopt a single policy rate from 27th November 2024 marks a major shift in monetary policy. For banks and financial institutions, this change simplifies the playing field but also brings new challenges and opportunities. The Good News: 1️⃣ Simplified Pricing: With one benchmark rate, banks can now set lending and deposit rates with greater clarity and confidence, making loan pricing and deposit offerings more transparent. 2️⃣ Better Liquidity Management: Treasury operations become more predictable, helping banks optimize their liquidity strategies. 3️⃣ Increased Trust: Transparent rate-setting aligned with global best practices can foster stronger customer relationships and attract foreign investors. The Challenges: ⚠️ Repricing Risks: Transitioning to a single rate requires careful balancing of assets and liabilities to avoid profit margin pressure. ⚠️ Market Competition: Clearer benchmarks mean intensified competition, as banks strive to offer the most attractive rates and products. ⚠️ Short-Term Volatility: Initial adjustments may lead to temporary market disruptions, testing banks’ resilience. What’s the Opportunity? This is a chance for banks to innovate and differentiate. Clearer monetary signals allow for better-aligned products, stronger customer engagement, and a foundation for long-term growth. CBSL’s new framework is a step toward modernizing Sri Lanka’s financial system. For banks, it’s time to adapt, innovate, and embrace the change. What’s your take on this landmark move? Share your thoughts below! #SriLanka #Banking #CBSL #MonetaryPolicy #Finance #SLBA