Interest rate plateau

inSight

06 Apr 2006

Interest rate plateau

The interest rates may be about to reach a plateau, but it does not look like a peak is forming yet.

As interest rates have returned to their "normal" levels (or perhaps beyond, depending on the historical period used for reference), the interest outlay of borrowers has become more significant than before. Although, given the general robustness of the economy, the burden of interest payments should still be manageable for most, borrowers obviously will not welcome further increases in that burden. Beyond a certain point, the buoyancy of economic activity, notably consumption and investment, will be dampened. Indeed, this may well be the aim of monetary policy in the United States, given the concern about inflation associated with brisk economic activity. But the interest rate tool - the only monetary policy tool - is always very blunt, affecting different people and different sectors of the economy differently, according to the reliance of each on borrowed money.

It is, of course, for those who are dependent on borrowed funds to finance their activity, including home buyers, to decide what they can afford, having regard to the current level and the likely trend of interest rates, and plan or adjust their activities accordingly. For financial institutions, such as banks, with assets and liabilities being sensitive to interest rate changes to varying degrees, the management of interest rate risks is an important, in fact a day-to-day task. To be able to do so effectively, and possibly avoid debilitating consequences of neglecting such risks, all concerned should, as far as possible, develop a good appreciation of how interest rates behave. This involves crucially appreciating how monetary policy is determined.

In Hong Kong, the situation is rather more complicated than in many jurisdictions, whose central banks have discretion to determine interest rates, some according to the needs of the economy and others, increasingly, in accordance with a well-defined quantitative target (such as an inflation target) for monetary policy. There is no doubt that the monetary policy objective of a fixed exchange rate is most suitable for Hong Kong, considering our circumstances. But it does present greater difficulties for anyone wanting to predict the trends of our own interest rates. Apart from having to understand the formulation of monetary policy in the United States, we need also to understand the structural characteristics of our own monetary system. As we are aware, notwithstanding the close, long-term relationship between Hong Kong dollar and US dollar interest rates, there can in practice be sharp, short-term deviations arising from short-term flows of funds in and out of the Hong Kong dollar. With so much focus on the renminbi and the occasional questions about the long-term, future relationship between the Hong Kong dollar and the renminbi, these flows may be quite large. The situation is further complicated by a domestic money market that has a relatively high degree of concentration and a highly rule-based monetary management system that deliberately eschews discretionary market operations.

It is always a responsibility of monetary authorities to provide their points of view when necessary, whether it is to guide the money market in a direction consistent with monetary policy or to inject a degree of objectivity among those wishing to make predictions or, to use an increasingly popular term in monetary management, to anchor expectations. These are the purposes of the occasional comments from me or my colleagues in the HKMA on interest rates and indeed on other subjects where we think risks require greater attention if general financial stability is to be maintained. Such comments are calculated to stimulate attention and discussion and, we hope, action to manage the risks concerned. They may also draw controversy, for whatever reasons, but this will not stop us from commenting where comments are needed, and our press friends provide us with ample opportunities for doing so.

Perhaps a further comment on interest rates is appropriate at this point, although it sounds more like a comment on topography, or advice for hikers. When you reach a peak, you can only climb down; unlike a plateau where you can, if you wish, take a breather, particularly after climbing continuously for so long, survey the surroundings and then decide whether to stay on it, find a way down or go for higher ground. Of course, there is a possibility, hopefully remote, that the climate may deteriorate when on the plateau that you wish to climb down quickly and take shelter. For the time being, it looks like the ground will soon level off, but it does not look like a peak to me.

Joseph Yam

6 April 2006

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