Interest rates and how they reach prices
For the members of the Financial Market Club, FSJES
An interest rate is the price of using someone else's money. Like any price, it can be quoted in two ways, and only one of them tells you the real cost.
Nominal and real#
The nominal rate ignores inflation. The real rate subtracts expected inflation from it. Mishkin calls this the Fisher equation: real rate = nominal rate - expected inflation.
His two examples:
- A loan at 5% when you expect 3% inflation pays you 2% in real terms.
- A loan at 8% when you expect 10% inflation leaves the lender 2% worse off in real terms. The borrower gains 2%.
Mishkin's conclusion is that the real rate is the better guide to how people behave. When it is low, borrowers have more reason to borrow and lenders less reason to lend.
A Moroccan illustration: Al Maliya reports that the weighted average rate on Treasury bills at the end of March 2016 was 2.7%, and inflation over the first quarter was 1%. That suggests an annualized real return of about 1.7 points. This mixes a rate at one date with an inflation figure for a quarter, and it uses realized inflation instead of expected inflation. Treat it as a practical exercise in financial arithmetic.
From the central bank to the economy#
Mishkin describes the traditional transmission channel with a short chain: more money supply leads to a lower real interest rate, which lowers the cost of capital, which raises investment spending, which raises output. Consumer spending on housing and durable goods follows the same logic, since those purchases are investment decisions too.
A puzzle follows. Central banks control short-term nominal rates. Why would that change the real rate, and a long-term rate on top of that? Mishkin gives two reasons:
- Prices are sticky. They adjust slowly, so a lower nominal rate also means a lower real rate for a while.
- Long-term rates reflect an average of expected short-term rates, so lower short-term real rates pull long-term real rates down.
Mishkin also describes a second route through the exchange rate. Lower domestic real rates make domestic deposits less attractive, the currency softens, domestic goods become cheaper abroad, and net exports rise. In Morocco, Bank Al-Maghrib operates within a currency basket anchored to the Euro (60%) and US Dollar (40%), which limits exchange rate volatility while transmitting global monetary conditions into domestic dirham liquidity.
Rates also move prices of securities#
In the bond market, price and interest rate move in opposite directions. A discount bond with a face value of 1,000 dirhams sold at 950 yields (1,000 - 950) / 950, or 5.3%. At a price of 900, the yield is 11.1%. That is why financial reports about "falling rates" are also reports about rising bond prices.
On the Casablanca exchange, when Treasury yields decline, equities become comparatively more attractive, lowering corporate discount rates and expanding valuation multiples across listed companies like Maroc Telecom and Attijariwafa Bank.
For discussion#
- Al Maliya reports that equipment credit in Morocco rose 1.0% in the first quarter of 2016, its first increase since 2012, while overall bank credit fell 2.1%. Does that fit Mishkin's chain? What else would you need to know?
- If expected inflation rises by 2% and nominal rates on Moroccan Treasury bills do not move, what happens to a bank's real return on its government bond portfolio?
- When Bank Al-Maghrib cuts its policy rate, why do short-term Treasury bill yields adjust within days while corporate bank loans take months to reflect the change?
For the members of the Financial Market Club, FSJES. Moroccan figures describe 2015 and early 2016, so check current numbers before citing them.
Sources: Mishkin, The Economics of Money, Banking, and Financial Markets, 7th ed., chapter 4 (real and nominal rates, Fisher equation), chapter 5 (bond prices and yields) and chapter 26 (transmission mechanisms). Al Maliya n°60, June 2016, section "Reperes" (Treasury rates, inflation and credit data). Bank Al-Maghrib monetary policy reports.