Monetary policy in inflation-targeting countries such as SA relies on the central bank being able to influence the interest rates households and businesses encounter in the real world. While most people will be aware of the policy rate as set by their central bank, few know much about how the policy rate feeds through to the economy. Yet these mechanics are crucial to the success of monetary policy and financial market development. Current reform efforts in SA will allow fundamental changes to these mechanics.

In a speech delivered on October 8, US Federal Reserve chair Jerome Powell spoke about the need to maintain an appropriate level of reserves in the banking system. (A simple way to think of reserves is that they are deposits the commercial banks hold with the central bank.) This was said in the context of recent volatility in the market-determined federal funds rate, the interest rate at which commercial banks lend reserve balances to each other.

The Fed has a target range for the federal funds rate (set by the federal open market committee eight times per year). If the rate does not trade within this, its monetary policy stance is undermined. This rate is therefore fundamental to the monetary policy transmission mechanism in the US, as the expectation is that the deposit and borrowing rates for households and businesses will closely track movements in the federal funds rate. The transmission channel is that the fed funds rate will influence other interest rates and pass all the way through to commercial and retail borrowing and lending rates.

While the Fed will monitor the federal funds rate, it also keeps an eye on the other money market rates as large dislocations between money market rates could endanger the transmission mechanism of its policy stance.

On September 16 and 17 such a dislocation occurred in the overnight repo market. The overnight repo rate is the rate at which banks will lend money against high-quality collateral. The repo rate had spiked as high as 10% during the day and pulled the federal funds rate briefly to 2.3%, above the target range of 2%-2.25%. This required the Fed to provide liquidity to reduce the upward pressure on rates. While such a breach of the target range may seem small, it is a rare occurrence and is viewed in a serious light by the Fed. Central banks prefer to intervene as little as possible when executing their policy mandate.

This volatility had been triggered by a confluence of transaction flows, which led to pockets of cash shortages in the market. However, the Fed believes a structural factor that may have contributed to this situation is the level of reserves — that is, the level of bank deposits at the central bank. In his speech, Powell argued that “without a sufficient quantity of reserves in the banking system, even routine increases in funding pressures can lead to outsize movements in money market interest rates”. Put simply, Powell believes banks should have sizeable deposits with the Fed to ensure stable money market rates.

Banks need to hold a minimum level of reserves by law, but here we are talking about reserves in excess of this minimum. Powell explained that this should not be seen as a new round of asset purchases (more commonly known as quantitative easing), but as a technical adjustment. This planned increase in reserves is just to ensure the cash liquidity in the market is at a level where markets can function effectively. When banks do hold such large excess balances at the central bank it is referred to as a liquidity surplus system.

The system in SA is fundamentally different. Here, instead of targeting a level for a market-determined interest rate, the SA Reserve Bank lends money to commercial banks at the policy rate, called the repo rate.

Embedded in this structure is that rather than there being a liquidity surplus there is a cash deficit for the banking sector, forcing the banks to borrow money from the Bank (it currently refinances the banking sector with R56bn a week). Like the Fed, the Reserve Bank wants the deposit and borrowing rates for households and businesses to follow movements in the repo rate. However, unlike the Fed, which has several market-determined interest rates it can monitor, there is a dearth of such rates in SA.

The Fed, like many other central banks, targets an interbank rate. Interbank markets tend to be liquid and efficient, thus providing a reliable source of pricing. In SA we do not have such a rate. One key reference rate is the Johannesburg interbank average rate (Jibar), which despite its name is not an interbank rate. The volumes underpinning these rates are tiny, and these are term rates (the shortest rate is one month).

The other benchmark rate is the SA benchmark overnight rate (Sabor). This is a composite of interbank lending, large corporate deposits and a small portion of secured lending transactions. Besides this being an undesirable blend of different types of transactions and counterparties, the volume underpinning this benchmark has been declining. In recent years the average volume of transactions used to calculate this rate has been R50bn, compared with R97bn at its peak from 2011 to 2012.

While there are other observable market rates, such as the interbank bond repo rate, each has its peculiarities and challenges for interpretation and usefulness. What the SA financial markets need is more transparency and certainty around pricing in the money market.

This will aid the Bank in its policy decision-making, improve the pricing of financial assets, enhance investment choices and assist businesses in financial decisions. In addition, it would allow the Bank to move away from the cash liquidity deficit model of monetary policy implementation to one where it targets a market-determined interest rate. Such a framework is likely to be more efficient and effective than the current model, as the Bank would probably need to intervene less in the market and banks would be able to manage their balance sheets more efficiently.

Fortunately, the Reserve Bank has already embarked on a process to reform the money market benchmark rates. It published a consultation paper in August 2018 and then a report on the stakeholder feedback in May 2019. One of the many proposals is to introduce a new interbank benchmark rate to be called ZARibor. The actual work of the reform is being done via a new body called the market practitioners group, which includes representatives of all key interested parties such as banks, fund managers and corporate treasurers.

This reform initiative is taking place in the context of a co-ordinated global effort to reform interest rate benchmarks and reference rates with the intention of strengthening the credibility of these rates. Significant progress has already been made in some countries. While we are in the fortunate position of being able to learn from the recent reform experiences in the main financial centres, the market practitioners group and its workstreams must enjoy all the support it can get from its constituents.

• Myburgh is a former head of the financial markets department at the SA Reserve Bank, and prior to that an interest rate and currency analyst.

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