We have a quick question here from Richard asking how changes in interest rates through something like QE bond buying how that affects the rates that commercial banks are willing to lend at.
Looking at this, I think the best way to look at it is by starting by looking at the various interest rates in the financial system, right? So at the top end, you have your cash rate or your bank rate.
In the case of the US, you have the Fed funds rate, and this is the interest rate that commercial banks borrow and lend that from each other overnight. And this rate is important because it sets the base for all the other interest rates in the real economy.
So after the cash rate or the Fed funds rate, you get the prime rate which is usually the average of the best interest rates that commercial banks will charge the most creditworthy customers. So of course, if you take a loan you might get it at prime minus one or prime minus two depending on the default risk.
So depending on that default risk of the credit worthiness, the bank will charge a risk premium above the prime rate usually to make up for that default risk of creditworthiness. So the type of loan obviously is also important.
You might have a secured loan or an unsecured loan or something like a mortgage. And depending on the default risk and the type of loan and the duration, that’ll of course affect the interest rate that the bank will charge. So how does this come back to something like QE and open market operations of bond buying?
Well, if the central bank wanted to keep borrowing costs low in the short-term, they would simply just lower the cash rate, right? And by lowering that, they will obviously lower the prime rate and all the other and short-term rates as well.
Now, it’s also true that a commercial bank might not charge lower on interest, just because the central bank lowered the cash rate. But that would be bad for business on their part because if I can get a better interest rate from the bank next door, and I can basically refinance at a lower rate and ease up some cash flow, of course, I’m gonna do that.
So, to stay competitive they usually follow suit with the Fed. So to come back to the central bank, if they wanted to lower those short-term borrowing costs for the economy, they would just lower the cash rate which will lower the prime rate, which will lower all the other lower end rates which basically dependent on the cash rate.
That’ll mean, lowering rates for things like credit cards, vehicle short-term loans, et cetera. But how about the more longer-term loans like company or corporate loans or mortgages etc. So you see bond yields are usually the basis, especially longer dated bonds like the 10 years are usually the basis for all longer-term interest rates. So by doing QE and keeping yields as low as they can, they are basically in fact keeping longer-term borrowing costs lower as well.
But then the central bank basically buys tons of bonds in the open market from the same commercial banks which increases their reserves, and the central bank can also further increase commercial banks excess reserves by lowering the rate at which banks can borrow from the Fed itself, which in this case for the Fed is called the discount rate.
So, with all the excess reserves created by the Fed, the Fed is basically increasing the money supply in the system. And the more money in the system, the more reserves are available to lend out, and the central bank could even do something like reducing the reserve requirements, which basically lowers the minimum amount of money that the commercial bank needs to keep on the books. The bank has ample reserves due to the Fed injecting cash, and then with the Fed also doing QE, they’re also lowering bond yields, which is the base for the longer-term interest rate.
So, with ample reserves and lower shorter as well as longer-term interest rates, the commercial bank starts competing with each other to try and lend out money and offer more and more attractive interest rates, which obviously appeals to customers and businesses to try and beat out the competition.
So it’s all done by the central bank to try and make money as cheap as they can, or to make borrowing as attractive as they can for both businesses and consumers. And if the central banks doesn’t join in the party and lower rates as well, they will simply just lose out in business due to the competition in the system.