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Interest Rates and Monetary Policy
18 Jun 2018
In order to maintain price stability, healthy levels of employment and a balanced economic growth, central banks uses a number of tools to influence high level dynamics in an economy. Indeed, central banks through the use of monetary policy tools can fully determine the level of interest rate in an economy. In addition to steering interest rates by managing liquidity, the central bank can also signal its monetary policy stance to the money market. This is usually done by changing the conditions under which the central bank is willing to enter into transactions with credit institutions.

Monetary policy decisions implemented by central banks leave intended and unintended effects on the economy. The transmission mechanism of such decisions is characterised by long, variable and uncertain time lags which make it difficult to measure the effect of monetary policy actions on the economy.

Changes in the official interest rates directly affect money-market interest rates and, indirectly, lending and deposit rates offered by banks to their customers. Thus interest rate changes affect the supply of credit in an economy. For example, following the financial crisis, major central banks worldwide eased heavily their monetary policies. Some central banks, like the Federal Reserve Bank (FED), the European Central Bank (ECB), and the Bank of England (BOE), lowered heavily the level of interest rates and conducted other extraordinary measures like quantitative easing and forward guidance to bring down short and long-run borrowing costs and stimulate the economy. This in turn made bank loans cheaper to entice consumers and firms to borrow more money to increase their consumption and investments.

This, in turn, increased the level of domestic demand for goods and services relative to domestic supply in an economy. When aggregate demand supersedes aggregate supply, upward price pressure is likely to occur. Changes in aggregate demand may also translate into tighter or looser labour market conditions. Consequently, this affects price and wage-setting in the respective market.

The future path of interest rates is a very popular guess amongst market participants, particularly among economists and investors. Events like monetary policy meetings held by central banks are scrutinised by financial markets to gauge any changes in interest rates guidance. In the case of European interest rates, the ECB did not deliver any surprises during its 26 April 2018 monetary policy meeting, leaving its ultra-accommodative monetary policy stance unchanged and refraining from offering any guidance on the future of its bond-buying program and interest rates. ECB President Mario Draghi stated that, “interest rates will remain at their current levels for an extended period of time, and well past the horizon of our net asset purchases”. Draghi stressed that European core inflation has remained low and an ample degree of monetary stimulus is still necessary, despite the European economy showing strong signs of recovery.

Going forward, the European interest rates figures will be highly dependent on core data coming out of Europe. To hike up interest rates the ECB will have to see a sustained economic recovery in Europe with core inflation reaching its target at two percent. According to a poll of around eighty economist conducted by Reuters, inflation is not due to reach the Central Bank’s target until at least 2020. Moreover, the majority of economist sees a very gradual increase in European interest rates starting in the second half of 2019. This suggest that we are in for a long wait before interest rates start to pick up in Europe.

On the other hand, both the Fed and the BOE started raising interest rates in response to higher inflation data and better economic conditions in their respective countries. Indeed, the official US interest rate has gone up from 0 percent in December 2015 to 1.75 percent today while the BOE raised its official bank rate by 0.25 percent in November 2 2017.

Peter Paul Cilia, CFA, is a Portfolio Manager at BOV Asset Management Limited

Published on The Times of Malta on Sunday - 17th June 2018

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Bank of Valletta p.l.c. is a public limited company regulated by the MFSA and is licensed to carry out the business of banking and investment services in terms of the Banking Act (Cap. 371 of the Laws of Malta) and the Investment Services Act (Cap.370. of the Laws of Malta).