Understanding Interest Rates

• Interest rates are the price paid for using money for a period, expressed as a percentage of the outstanding balance.
• Interest rates can be defined from the borrower's perspective (borrowing rate) or the lender's perspective (lending rate).

Classification of Interest Rates

• Interest rates are classified by the tenor or maturity period of the borrowed funds.
• Short-term rates are for less than one year.
• Medium-term rates are for more than one year but less than five years.
• Long-term rates are for more than five years.
• Interest rates vary based on the type of instrument (e.g., deposit accounts, bonds) and the tenor of investment.

Real Interest Rates

• Real interest rates are adjusted for the expected decline in purchasing power due to inflation.
• Real interest rates influence consumption and investment decisions, affecting aggregate demand.
• Central banks can only set the short-run nominal policy rate, which serves as a benchmark for market rates.
• Central bank policy actions influence not only market rates but also inflation expectations, affecting real returns on funds.
• Example: A £1,000,000 investment with a 10% nominal annual return yields £1,100,000 at year-end.
• With 5% annual inflation, the real value is £1,047,617, resulting in a 4.8% real return.
• The formula for real interest rate is r = (i-π)/(1+π), approximated by r=i-π at low inflation rates.

Yield Curve

• Economists use the yield curve to capture the overall movement of interest rates.
• It plots the day's yields for various maturities of Treasury bills (T-bills) and bonds.
• Government T-bills and bonds are issued through yield auctions to generate cash for the National Government (NG) in the primary auction market.
• Secondary trading occurs in the over-the-counter (OTC) market.
• As of end-March 2020, yields for government securities (GS) in the secondary market generally increased, except for 10-year and 20-year GS, relative to end-December 2019, due to market uncertainties over the coronavirus pandemic, Taal volcano eruption, and geopolitical concerns.

Interest Rate Determination

• Interest rates are determined by the interaction of supply and demand for funds in the money market.
• Before full liberalization in 1983, interest rates were set by the Bangko Sentral ng Pilipinas (BSP).

BSP's Policy on Interest Rates

• Since 1983, the BSP has followed a market-oriented interest rate policy, allowing the market to set rates.
• The BSP requires that interest rates be indicated on pawn tickets for pawnshops, promissory notes for lending investors, and loan agreements for bank loans.
• The Monetary Board sets rates for the BSP's overnight borrowing and lending facility to stabilize the price level.

BSP Intervention

• The BSP shifted to a market-oriented interest rate policy in 1983 due to the limitations of administratively fixed rates.
• The BAP implemented a gentleman's agreement to cap the spread of bank lending rates at a maximum of 5% over the 91-day T-bill rate in the secondary market.
• The BSP can effectively set interest rates under the Usury Law, prescribing maximum rates for loans.

Factors Influencing Interest Rates

• Interest rate movements are affected by the price level or inflation rate, fiscal policy stance, and intermediation cost.
• The BSP's policy direction influences the interest rate level, increasing key policy rates to curb inflationary pressures.
• A higher fiscal deficit increases the demand to borrow, exerting upward pressure on domestic interest rates.
• High intermediation costs, including administrative costs and the BSP's reserve requirements, contribute to higher interest rates.
• Other factors include the maturity period of the financial instrument and the perception of risks.

Interest Rate Corridor (IRC)

• An IRC guides money market rates towards the central bank's target/policy rate.
• The IRC consists of standing liquidity facilities like the overnight lending facility (OLF) and the overnight deposit facility (ODF), the overnight reverse repurchase (RRP) facility, and a term deposit auction facility (TDF).
• Adoption of an IRC system strengthens monetary policy transmission.
• The IRC promotes greater interbank market activity and the establishment of benchmarks for short-term interest rates.

Differences in Interest Rates Among Banks

• The cost of doing business varies from bank to bank.

Interest Rates Monitored by the BSP

• Overnight Lending Facility (OLF) Rate: rate at which the BSP lends reserves to commercial banks.
• Overnight Deposit Facility (ODF) Rate: rate at which the BSP takes deposits from commercial banks.
• Term Deposit Facility (TDF) Rate: rate on the term deposit facilities at which the BSP takes deposits from commercial banks.
• Overnight Reverse Repurchase (RRP) Facility Rate: rate on the RRP facility at which overnight RRP agreements are offered to banks.
• Treasury bill (T-bill) Rate: rate on short-term debt instruments issued by the NG.
• Interbank Call Loan Rate: rate on loans among banks for periods not exceeding 24 hours.
• Philippine Interbank Offered Rate (PHIBOR): represents the simple average of the interest rate offers.
• Philippine Interbank Reference Rate (PHIREF): the implied interest rate on the peso derived from completed USD/PHP transactions.
• PHP BVAL Reference Rates: benchmark rates for the Philippine peso in the GS market.
• Time Deposit Rate: weighted average interest rate charged on interest-bearing deposits.
• Savings Deposit Rate: rate charged on all interest-bearing deposits of banks.
• Bank Average Lending Rate: weighted average interest rate charged by commercial banks on loans.
• Lending Rate: range of lending rates reported by commercial banks.

Gap Between Savings Deposit and Lending Rates

• Reflects interest rates charged on loans, covering costs, overhead, and profit margins.
• Represents the risk premium assigned to a particular loan exposure.

Implications of Interest Rate Levels on the Economy

• Low interest rates encourage borrowing, speeding up economic growth and benefiting banks.
• High interest rates tend to reduce borrowing for investment, slowing economic growth.

Interest Rate Developments Since the Mid-1990s

• T-bill rates generally declined since mid-1998, reaching their lowest in 2002, then rose until 2004.
• T-bill rates eased in 2005 and 2006 due to decelerating inflation and ample liquidity.
• The downtrend in T-bill rates continued until April 2007, then rose due to uncertainties.
• In 2008, T-bill rates trekked a general uptrend due to higher inflation and risk premiums.
• Beginning 2009, short-term interest rates eased following rate cuts.
• In 2012, domestic interest rates started to increase due to cautious market sentiment.
• In 2014, average T-bill rates edged higher as investors sought yields.
• In 2017, T-bills increased due to geopolitical concerns.
• In Q1 2020, average interest rates for T-bills rose but a declining trend was seen mid-quarter following policy rate cuts and demand for government securities.