Open Market Operations, Interest Rate Corridors and the Inter-bank Offered Rate

Abstract

In recent years, there have been sharp fluctuations in short-term interest rates in China’s financial markets, posing challenges to the implementation of monetary policies and the stability of financial markets. There was a similar phenomenon in LIBOR rates of major currencies during the financial crisis. After the financial crisis, the interest rate corridor” gradually became a new trend of monetary policies, and the central bank of China gradually introduced a similar mechanism to implement monetary policies. This paper sets up a three-phase model of the inter-bank market, expanding the traditional analytical framework into a peer-to-peer market with OTC market attributes. This approach enables the model of this paper to characterize the heterogeneous characteristics of the bank’s liquidity, and distinguish between banks which need interest rate corridors and those which have no need of the corridors, so that the unique mechanism that interest rate corridors affect market liquidity can be reflected. The establishment of the interest rate corridor mechanism will affect the liquidity position of commercial banks by affecting the expected liquidity management costs and benefits of commercial banks. Thus, the inter-bank offered rate can be impacted and it will be stable within interest rate corridors. In order to highlight the unique mechanism of the interest rate corridor mechanism, this paper first analyzes the impact of open market operations with characteristics of quantitative regulation on market interest rates, and demonstrates the advantages and disadvantages of the interest rate corridor mechanism through comparison. The theoretical analysis shows that open market operations and interest rate corridors have their own advantages and disadvantages in regulating interest rate fluctuations. First, open market operations regulate interest rate volatility by regulating the liquidity of the whole interbank market. Interest rate corridors only need to adjust the liquidity of part of the banks to regulate interest rate fluctuations, so interest rate corridors affect market activities from the margin, and the regulation has less disturbance to the market. Second, in terms of regulating short-term interest rates, both the expected open market operations and interest rate corridor adjustments will be constrained by the liquidity substitution effect”. Because of the liquidity substitution effect, the adjustment of open market operations may be completely offset, but that of interest rate corridors cannot be. In terms of stabilizing interest rates, open market operations rely on the judgment of the central bank, while interest rate corridors can be more independently implemented. Finally, under the interest rate corridor mechanism, a tight mortgage policy may cause the inter-bank offered rate to break through the interest rate corridor ceiling. However, the central bank can adjust the mortgage policy, using the camera selection strategy and the cooperation with macro-prudential management, which can respectively achieve different purposes for post-hoc response and pre-existing prevention.