Role of central bank in price discovery
Monetary policy in most countries is directed at influencing interest rates, specifically bank lending rates, and this certain central banks are able to achieve in spectacular fashion. As we have covered this issue in a previous section, we will not repeat it here.
Chart 6: call money rate, interbank rate & KIR
What we need to point out is that central banks are able to achieve this provided they "make the KIR effective" and this achieved by ensuring that the banks are indebted to it at all times. Under this condition of a permanent liquidity shortage the KIR has a major impact on the b2b IBM and on bank call deposit rates (see Figure 6: this figure applies to a particular country for 13 years) and on banks' other deposit rates. This is so because banks compete aggressively to avoid borrowing from the central bank at the KIR (= the highest short-term rate).
Because banks endeavour to maintain a healthy margin, the KIR therefore has a major impact on the banks' prime lending rate (PR - see Figure 7). This rate has a major influence on the demand for loans and therefore on the rate of money creation.
What does this mean in terms of price discovery? It means that short-term rates are always discovered with reference to the KIR. Even longer rates (see Figure 8) can be said to be determined with reference to KIR - because the short end of the yield curve is largely "determined" by the central bank's KIR.
This brings us to the composition of interest rates.
Figure 7: KIR & PR (month-ends over 50 years)
Figure 8: normal yield curve
Composition of interest rates
Prices discovered in the debt markets (i.e. interest rates) are made up of a number of elements. Many versions of this analysis exist in scholarly works. We present an alternative analysis that begins with the 1-day risk-free rate (rfr), i.e. the rate on F 1-Ury treasury bill (see Figurer X
Figure 9: composition of nominal rates
Irving Fisher in his Theories of interest in 1930 was the first scholar to "split" the nominal interest rate. He postulated that the nominal interest rate (i.e. the observed interest rate) (nr) is approximately equal to (and is therefore comprised of) the real rate (rr) and the expected inflation rate (e7r). At low levels of rates and inflation this may be expressed as:
Essentially Fisher hypothesized that lenders demand a premium over the real rate of interest to compensate for the inflation-induced erosion of their monies lent. He asserted that nominal interest rates adjust in line with expected changes in the rate of inflation. In other words, the nominal rate, determined by market forces, is comprised of expected inflation and the real rate of interest (which is determined by the marginal productivity of capital30). Fisher did not state the term of asset he was referring to or its status in terms of risk. Neither did he refer to the rfr.
Composition of the nominal risk-free rate
If we apply the Fisher equation of our definition of the 1-day nominal rfr (nrfr), it could be expressed as:
The 1-day nominal rfr (nrfr), which is determined by market forces, is equal to the 1-day real rfr (rrfr) plus the current rate of inflation (c7r). Note that the rfr does exist and can be obtained from the market. The latest inflation rate can be termed current, because the last published inflation rate, at worst is 6 weeks old and at best 2 weeks old31. Also, in a low inflation environment, it is unlikely that the next published inflation rate will differ much from the last one (it may differ by a few decimal points - e.g. change from 2.2% to 2.4%).32 This is small enough to disregard. The composition of the nominal rfr may be depicted as in Figure 9.
Figure 10: composition of nominal rates
The 1-day rrfr can also be seen as the component of the nrfr that represents lenders' sacrifice of consumption for 1 day in a steady price setting. It may also be seen as being determined by the interplay of the supply of and the demand for funds, i.e. a measure of the equilibrium point of the eagerness of the lenders to lend and the eagerness of borrowers to borrow (for one day). We hasten to add that this statement is extremely simplified but it will do for this purpose.