Neutral interest rate in practice of the National Bank of the Republic of Belarus

In the process of analyzing monetary policy, a large number of central banks assess the monetary conditions index. The concept of monetary conditions was for the first time proposed in the early 1990s in the Bank of Canada and subsequently became widespread in central banks.

The monetary conditions index is a combination of deviations of the real interest rate and the real exchange rate from their equilibrium levels.

A key role in determining monetary conditions is given to the interest rate component. It is the interest rate that is used by the majority of central banks, including the National Bank of the Republic of Belarus, as the operational target of monetary policy. The change in interest rates of the central bank has a direct impact on the exchange rate, which is the second component of monetary conditions.

Monetary conditions reflect the combined effect of interest rates and exchange rate on the economy of the state. Tight monetary conditions, as a rule, are formed under the influence of the central bank’s activities aimed at curbing price growth in order to prevent inflation from exceeding the target. On the contrary, if the inflation is expected to be much lower than the target the central bank’s actions are usually aimed at creating easy monetary conditions. Neutral monetary conditions do not lead to either a reduction or an acceleration of inflation.

The concept of a neutral (equilibrium) interest rate is of decisive importance in calculating the interest rate component of monetary conditions. A neutral interest rate is a real interest rate corresponding to a stable presence of inflation and inflationary expectations at the level of the target, and an output in the economy and the exchange rate at mid-term equilibrium levels. Thus, the interest rate component of monetary conditions is a deviation of the actual real interest rate from its neutral level, which directly determines the stance of the interest rate policy being pursued. If the actual real and neutral interest rates are equal, the interest rate policy is neutral.

The neutral interest rate is determined solely by structural (fundamental) factors, and monetary policy does not have a direct impact on its level. According to the uncovered interest rate parity, the level of the neutral interest rate in the countries with small open economies, including the Republic of Belarus, depends on the level of the neutral interest rate in the trading partner countries, the expected change in the equilibrium real effective exchange rate (RER) and the equilibrium risk premium (in Russian only) of foreign investors to protect against the risk associated with changes in the exchange rate.

The change in each of the above-mentioned indicators will have a direct impact on the neutral interest rate in the Republic of Belarus. Thus, other things being equal, the reduction of the neutral interest rate in the trading partner countries will also lead to a decrease in the neutral interest rate in the Republic of Belarus. Reducing the equilibrium risk premium, for example, in case of an increase in the investment rating of the Republic of Belarus, will also result in a proportional decline in the neutral interest rate. The lowering of the neutral interest rate in the Republic of Belarus can also be caused by a slowdown in the equilibrium rate of the national currency depreciation, for example, with a steady growth in the efficiency of the national economy functioning.

The neutral interest rate is an unobservable variable, which involves the use of different methods for calculating it. In the National Bank of the Republic of Belarus, the level of the neutral interest rate is estimated using a set of macroeconomic models, the core one being the medium-term projection model of the National Bank’s monetary policy.

The deviation of the actual real interest rate of the overnight interbank market in Belarusian rubles from the neutral level is published on a quarterly basis in the analytical review “Major Trends in the Economy and Monetary Sphere of the Republic of Belarus” (in Russian only). The analysis of factors that form the neutral refinancing interest rate in the Republic of Belarus is represented in the paper of Mironchik (2018) (in Russian only).

FREQUENTLY ASKED QUESTIONS (FAQ)

The interest rates that economic agents observe in everyday life are almost always nominal. It is the nominal interest rate that is indicated in the loan or deposit agreement. For example, the nominal rate on a bank deposit shows the amount of monetary funds that a bank pays to a depositor for the use of his/her free resources. However, the nominal interest rate does not reflect the purchasing power of the income received from the placement of the deposit, i.e. the number of goods and services that a depositor will be able to purchase. With a view to determining the income, it is necessary for a depositor to adjust the nominal income from the deposit placement for the change in prices for relevant goods and services. Thus, on a national scale, the real interest rate is the quantity of goods and services that the investor can purchase for the income received from investment, and is calculated by adjusting the nominal interest rate for inflation.

There are two types of real interest rate: ex ante and ex post. The ex ante real interest rate is expected at the time a loan is granted or a deposit is placed and is calculated by adjusting the nominal interest rate for the expected inflation. So, if a depositor places funds in a deposit at 8 percent per annum with a one-year maturity, while expecting a price increase (inflation) for the deposit period by 5 percent, the ex ante real interest rate will be about 3 percent per annum. Let us suppose that the actual inflation rate for the deposit placement period was 4.5 percent instead of the expected 5 percent. In this case, the ex post real interest rate, or the actual real interest rate, will be about 3.5 percent per annum.