The Central Bank of Barbados (CBB) is launching a new approach to influencing interest rates by intervening directly in the market for Treasury bills instead of using the minimum deposit rate as a guide to affecting commercial banks' lending rates and thus economic activity.
The rationale behind the new policy was unveiled in a CBB working paper from last month - Central bank intervention and interest rate policy in Barbados - that laid out the limitations of using interest rates to control inflation in a country like Barbados where 80 percent of inflation is imported.
"It has been the experience in Barbados that monetary policy cannot relieve any pressure that might aggravate imported inflation; for instance, it will not achieve low domestic inflation rates in an environment where international oil and commodity inflation is high," the paper said.
Under the new policy, which will begin on April 18, the CBB said it would "from time to time intervene actively in the Treasury Bill market to influence the average rate at which the bills are sold."
The coupons on all longer-dated government securities will be priced at an appropriate premium over the Treasury bill rate and the central bank will publish a quarterly yield curve to provide guidance to the market.
"With the introduction of this policy, the minimum deposit rate will no longer be used for interest rate guidance," the CBB said.
However, the banks said it would continue to stipulate a minimum savings rate for the savings accounts of private individuals and non-profit organisations - currently at 2.5 percent - to partially insulate small savers against the erosion of the value of their funds due to inflation.
Financial institutions will be free to set all other rates, the CBB said.
In a small, open economy like Barbados, the policy of targeting a deposit rate to guide the local availability of credit was weak because banks, firms and households went abroad to obtain funds.
"In these circumstances, interest rate policy cannot fulfill its conventional role," the CBB said in its working paper from last month, adding that changes in interest rates had little or no effect on inflation.
In addition, domestic interest rates had to be kept in line with international rates to "avoid incentives for destabilizing inflows and outflows of capital," the bank said, adding there was a longstanding view that keeping rates low to boost investment did not work because there was an incentive for an outflow of funds, "thereby starving the domestic system of investible liquidity."
In the future, the CBB will base its interest rate policy on two factors that will help it determine a notional policy rate, with an allowance for an appropriate spread: The trend in international interest rates and whether there is a need for a temporary inflow of finance to boost domestic liquidity.
The CBB will use the three-month Treasury bill rate as the market-determined benchmark and other government securities would be based on this T-bill rate.
"Where warranted, the Central Bank’s intervention in the T-bill market would signal to the market the need for interest rate adjustments, if there is a sustained change in the U.S. and domestic interest rate spread or if there is a continuous shortfall in T-bill auctions.
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