■ The Riksbank’s

management of interest
rates – monetary policy in
practice
BY ANNIKA OTZ
Annika Otz works at the Market Operations Department.

The Riksbank’s interest rate management is the operational component

of its monetary policy process. Through its interest rate management, the
Riksbank implements the Executive Board’s monetary policy decisions by
influencing the market’s shortest interest rate, the overnight rate.
Knowledge of how the Riksbank steers interest rates is thus important for
those wishing to gain a more in-depth understanding of the Bank’s mon-
etary policy.
A previous article1 in this journal explained the Riksbank’s interest
rate management in the light of the traditional approach for inflation tar-
geting given in textbooks, coupled with a comparison with the system
used by the US Federal Reserve. The aim of this article, besides elucidat-
ing how monetary policy is implemented in practice, is to further clarify
the connection between the steering of interest rates and the Riksbank’s
payment system.

Fundamental conditions for the Riksbank’s

management of interest rates
The banks’ borrowing When banks need to borrow or deposit funds in kronor, they can do so
or deposit requirement
with each other at different maturities. The most interesting maturity,
overnight constitutes
the essence of the which constitutes the essence of the Riksbank's ability to influence inter-
Riksbank’s management est rates, is the banks' borrowing or deposit requirement overnight.
of interest rates.
Banks’ need to borrow funds from, or deposit funds with, each other
Interbank payment overnight stems from the payments that occur between them during the
transactions require a
common payment day. But in order for banks to be able to carry out these payment transac-
system. tions at all, a common payment system is required.

1 Mitlid & Vesterlund (2001).

54 ECONOMIC REVIEW 2/2005

 THE RIKSBANK’S PAYMENT SYSTEM – A PREREQUISITE
FOR STEERING INTEREST RATES

When households and companies pay their bills they do so through the The Riksbank provides
a payment system,
bank in which they hold their accounts. The bank then forwards the pay- called RIX.
ment to the recipient’s account. If this account is held in a different bank
the process requires a payment system, that is to say, an infrastructure
that makes it possible to forward a payment from one bank to another. In
Sweden the Riksbank provides such a payment system, called RIX.2
Payments in RIX are made in Swedish kronor only and go via the
participant banks’ accounts at the Riksbank. Those banks that do not par-
ticipate in RIX have to go through the participant banks.
To ensure that payments can be made smoothly in RIX the Riksbank The Riksbank gives
participants the
gives participants the opportunity to borrow interest-free funds from the
opportunity to borrow
Bank during the day, known as intraday credit. The banks can do so on interest-free funds if
condition that they have provided sufficient eligible assets to the Riksbank. required, known as
intraday credit.
The payments in RIX are processed one by one, known as real-time
gross settlement, when payers have sufficient funds in their accounts or
adequate collateral to obtain intraday credit.

DEPOSITS AND LOANS AT THE RIKSBANK SET THE BOUNDARIES

FOR THE OVERNIGHT RATE

Before the payment system closes, the banks’ accounts in RIX must be
balanced. That means that banks with intraday credit at the end of the
day have to finance this in some way. Likewise, banks with a surplus in
their Riksbank accounts have to make sure that they deposit these funds.
Banks can resolve this by turning to the overnight market or by bor- Banks can turn to the
overnight market or
rowing or depositing funds at the Riksbank overnight, that is to say, by
make use of the
making use of the Riksbank’s marginal lending and deposit facilities (the Riksbank’s marginal
Riksbank’s standing facilities). In other words banks can extend their loans lending and deposit
facilities.
overnight (through the marginal lending facility) or deposit funds over-
night (through the deposit facility) at the Riksbank at interest rates
announced in advance.
The lending rate is 150 basis points higher than the deposit rate (see The lending rate is 150
basis points higher
Figure 1). This interest rate differential creates an incentive for banks to
than the deposit rate,
borrow from, and deposit with, each other at a rate of interest between creating an incentive
the Riksbank’s deposit and lending rates, thereby setting the boundaries for banks to borrow
from and deposit with
for the overnight rate.3 each other.

2 The Riksbank’s payment system RIX is a hub of the Swedish payment infrastructure. For more information,
see Sveriges Riksbank (2004a).
3 Banks usually have a liquidity plan that extends over a longer period than overnight. Nevertheless, the
overnight market is important for banks to be able to manage the deficits and surpluses that arise in their
payment flows on particular days.

ECONOMIC REVIEW 2/2005 55

 Figure 1. The Riksbank’s deposit and marginal lending facilities
(standing facilities)

Per cent

Lending rate
2.75 %
Negotiation
150 basis points range for the
overnight rate
Deposit rate
1.25 %

Banking 0 Banking
system’s deposit system’s borrowing
requirement requirement

Note. Interest rate levels as at 29 April 2005.

The Riksbank’s mode of procedure

The Riksbank wants the The Riksbank’s steering of the overnight rate is not only aimed at bringing
overnight rate to be
it within the interest rate corridor, however; the Riksbank also wants it to
close to and stable
around the repo rate. be close to and stable around the Bank’s key interest rate – the repo rate.
In other words the Riksbank wants the overnight rate to be predictable
over the coming week and not to fluctuate within the interest rate corri-
dor. That is because the Bank wants to give clear signals for longer-term
market rates. Since short-term market rates (up to six months or so) rep-
resent an average of the expected overnight rate at the respective maturi-
ties, a fluctuating overnight rate could give rise to unnecessary volatility at
these maturities. This could also create undue speculation over why the
overnight rate is lying closer to the ceiling or the floor of the interest rate
corridor. A sharply fluctuating overnight rate could therefore be misinter-
preted as monetary policy signalling.
The first step towards So how does the Riksbank ensure a stable overnight rate? The first
achieving a stable step is to ensure that the banking system’s need to borrow or deposit
overnight rate is to
minimise the banking funds through the standing facilities is minimised. Before going into this in
system’s need to more detail, we need to look briefly at how the banking system’s borrow-
borrow or deposit
funds through the
ing or deposit requirement vis-à-vis the Riksbank changes. The easiest
standing facilities. way to explain this is to take a simplified picture of what happens when
the public varies its demand for banknotes and coins.
When people demand more banknotes and coins they withdraw
them from banks, which in turn acquire the corresponding amount of
banknotes and coins from the Riksbank. However, the banks have to pay
for these notes and coins, which essentially means that they incur a liabili-

56 ECONOMIC REVIEW 2/2005

ty in relation to the Riksbank.4 If public demand for notes and coins
drops, the banks instead return the corresponding amount of notes and
coins to the Riksbank, thus decreasing their liability vis-à-vis the Riksbank.
Currently, the banking system as a whole has a borrowing require- The Riksbank has an
ment.5 In the absence of any Riksbank measures the banking system arrangement whereby
the banking system in
would borrow funds at the Bank’s lending rate (the marginal lending facil- the first place can
ity) and the market’s overnight rate would thereby be close to the lending borrow funds at the
repo rate.
rate. However, the Riksbank wants the overnight rate to be in the very
middle of the interest rate corridor. For that reason the Riksbank has an
arrangement whereby the banking system in the first place can borrow
funds at the repo rate. This is done as follows: Every week the Riksbank
forecasts the quantity of notes and coins that will be demanded by the
public. From this forecast, the Riksbank can interpret how much the banks
will want to borrow in conjunction with the Riksbank’s repo transaction
(repo)6. Through this repo the Riksbank satisfies the banking system's
borrowing requirement and also signals the level at which it wants the
overnight rate to be in the week ahead (see Figure 2).

Figure 2. The Riksbank’s official interest rates

Per cent

Lending rate
2.75 per cent
Repo rate
(key interest rate)
2.00 per cent
Lending rate
1.25 per cent

Bankings 0 Bankings
system’s deposit system’s borrowing
requirement requirement

Note. Interest rate levels as at 29 April 2005.

4 On condition that the banks can provide sufficient eligible assets to the Riksbank.
5 The banking system can just as well have a deposit requirement at the Riksbank. That is because the
Riksbank’s demand for assets to conduct monetary and exchange rate policy may exceed both the public
demand for banknotes and coins and the Riksbank’s capital. For example, under a fixed exchange rate,
appreciation pressures may force the Riksbank to purchase such large volumes of foreign currency that the
banking system as a whole needs to deposit funds at the Riksbank.
6 See step 2 for a description of a repo transaction (repo).

ECONOMIC REVIEW 2/2005 57

 To prevent the Since the Riksbank’s repo is based on a forecast for the following week
overnight rate from
the banking system's actual borrowing requirement will vary from day to
fluctuating within the
interest rate corridor, in day. That means that on certain days the banking system may need to
spite of the repo, the avail of the Bank’s standing facilities to borrow or deposit funds, and if the
Riksbank carries out
fine-tuning operations. amounts are large this could cause the overnight rate to fluctuate within
the interest rate corridor in spite of the repo. To prevent this from hap-
pening, the Riksbank carries out fine-tuning operations. These operations
involve meeting the banking system’s borrowing or deposit requirement
on a particular day at a rate of interest that is 10 basis points above or
below the repo rate.
In short, the Riksbank steers interest rates by providing standing facil-
ities through which it can fix the market’s overnight rate in the interest
rate corridor. By means of weekly repo transactions and (almost) daily
fine-tuning operations the Riksbank ensures that the overnight rate is an-
chored close to the repo rate (see Figure 3).

Figure 3. Negotiation range for the overnight rate

Per cent

Lending rate
2.75 per cent
Repo rate
+ 10 basis point
(2.10 per cent) Negotiation
Repo rate
range for the
Repo rate 2.00 per cent
overnight rate
– 10 basis point
(1.90 per cent)

Deposit rate
1.25 per cent

Banking 0 Banking
system’s deposit system’s borrowing
requirement requirement

Note. Interest rate levels as at 29 April 2005.

58 ECONOMIC REVIEW 2/2005

 The Riksbank’s practical implementation of
monetary policy
So what happens step by step when the Riksbank steers interest rates?

STEP 1. FORECAST OF THE SIZE OF THE MONETARY POLICY REPO

Every Tuesday the Riksbank forecasts how large the banking system’s bor- The forecast is based in
rowing requirement7 in relation to the Riksbank will be on average in the practice on the item
“banknotes and coins
coming week, that is to say, from Wednesday to Wednesday. The forecast in circulation”.
is based on an estimate of changes in the Bank’s assets and liabilities (the
balance sheet).
The Riksbank’s assets comprise the gold and foreign exchange re-
serve, which, besides gold, consists of securities denominated in foreign
currency and receivables from the International Monetary Fund (IMF). In
addition, the Bank’s assets are composed of other assets8 as well as lend-
ing to banks, which, in simplified terms, is due to the banks obtaining
notes and coins from the Riksbank. Thus, in principle, the item “lending
to banks” should equal the item “banknotes and coins in circulation”.
However, in order to be able to intervene in the foreign exchange market
and to generate as high a return as possible on its assets, the Riksbank
has chosen to exchange some of its claims on the banking system for for-
eign currency.
The Riksbank’s liabilities largely comprise banknotes and coins in cir-
culation as well as capital. In addition, the Bank's liabilities are composed
of deposits from banks and other liabilities9 (see Figure 4).

FIGURE 4. THE RIKSBANK’S BALANCE SHEET ( ADJUSTED ) AS AT 31 D ECEMBER 2004

Assets SEK million Liabilities SEK million
Gold and foreign exchange 162 649 Banknotes and coins 108 894
reserve in circulation
Lending to banks Deposits from banks
Monetary policy repos 16 473 Deposit facility 86
Marginal lending facility 2 Other liabilities 9 836
Other assets 3 205 Capital (incl. financial result 63 513
for the year)
Total 182 329 Total 182 329
Note: The item ”Monetary policy repos” includes fine-tuning operations (net).
Source: The Riksbank.

It is relatively easy to forecast changes in the Riksbank's assets because

generally speaking these items are influenced by the Bank's own deci-

7 In cases where the banking system as a whole has a deposit requirement and thus needs to deposit funds
during the week the Riksbank issues certificates (instead of implementing a monetary policy repo), which
means that the Riksbank pays weekly interest to the banking system for the deposited funds.
8 Other assets include accrued interest income and fixed assets.
9 Other liabilities include liabilities denominated in foreign currency and revaluation accounts.

ECONOMIC REVIEW 2/2005 59

 sions. This applies first and foremost to changes in the gold and foreign
exchange reserve that are connected to sales or purchases of foreign cur-
rency, which as a rule derive from intervention in the foreign exchange
market.
As regards the liability side it is generally only changes in the volume
of banknotes and coins in circulation, that is to say, public demand for
notes and coins, that needs to be forecast. This demand follows a clear
and stable seasonal pattern, making the item “banknotes and coins in cir-
culation” relatively easy to estimate. In the run-up to major holidays such
as Christmas, demand increases sharply.
The other items on both the asset and liability side display only very
small, predictable changes, for example payments to the State in connec-
tion with the allocation of the Riksbank's profits, which affects the Bank’s
capital, financial result and lending in Swedish kronor to the banking sys-
tem.
When the changes in When the changes in all the items have been estimated and summed
all the items have been
up, the Riksbank can see how the banking system’s average total borrow-
estimated, the Riksbank
arrives at the banking ing or deposit requirement at the Bank over the coming week will change
system’s borrowing or compared with the week before. In practice, this normally means that
deposit requirement.
only the item “banknotes and coins in circulation” needs to be forecast. If
the borrowing requirement has grown, the Bank increases the size of the
monetary policy repo and vice versa (see step 2).
Figure 5 shows how the different items in the balance sheet con-
tribute to the banking system’s total borrowing requirement at the
Riksbank. The example is based on the Bank’s balance sheet as at 31
December 2004.

FIGURE 5. CALCULATION OF THE BANKING SYSTEM ’ S TOTAL BORROWING REQUIREMENT

AT THE RIKSBANK AS AT 31 DECEMBER 2004
SEK million
Banknotes and coins in circulation 108 894
Deposit facility 86
Other liabilities 9 836
Capital 63 513
Gold and foreign exchange reserve – 162 649
Marginal lending facility –2
Other assets – 3 205
Banking system’s total borrowing requirement at the Riksbank and
size of the monetary policy repo (or banking system’s total deposit 16 473
requirement and size of the Riksbank’s certificate issue)
Source: The Riksbank.

60 ECONOMIC REVIEW 2/2005

 STEP 2. IMPLEMENTATION OF THE MONETARY POLICY REPO

Having arrived at the liquidity forecast and calculated the banking sys-
tem’s average total borrowing or deposit requirement10 the Riksbank
implements a monetary policy repo (or issues certificates).
The Riksbank’s repo11 is designed in the same way as an ordinary
repo instrument in the financial markets.12 Repos in the financial markets
are sale and purchase agreements whereby one party agrees to sell a
security to another party and to repurchase the security at a predeter-
mined price on a specific future date. The price of a repo is represented by
the repo rate, that is to say, the lending rate over the maturity of the
repo.13
As a rule, the monetary policy repo has a maturity of one week, from As a rule, the monetary
Wednesday to Wednesday. Thus, once a week the Riksbank buys securi- policy repo has a
maturity of one week.
ties from the banks and simultaneously agrees to resell them to the banks
a week later.
When the repo matures, the banks pay interest (the repo rate) on the
past week’s “loans”. At the same time, the Riksbank implements a new
repo, giving the banks the opportunity to renew their “loans” and there-
by “borrow” from the Riksbank for another week. The size of the “loans”
from the Riksbank may vary from week to week, however, depending on
the Riksbank’s forecast (see Step 1).
Because the repo in most cases has a maturity of only one week the
Riksbank can change the repo rate each week.14 In other words, one could
say that over time the banking system borrows funds at a variable rate of
interest from the Riksbank but that the rate is fixed for one week at a time.
So the starting point for the monetary policy repo is the banks' bor- The starting point for
the monetary policy
rowing requirement in relation to the Riksbank. The fact that the repo is
repo is the banks’
basically constructed as a purchase of securities in exchange for capital is a borrowing requirement
purely technical issue. The Riksbank could just as easily grant ordinary in relation to the
Riksbank.
loans with a maturity of one week in return for interest, with securities as
collateral for the loans.

10 It is usual to say that the banking system has a structural liquidity deficit or liquidity surplus, therefore
indicating how much liquidity the Riksbank needs to provide or absorb in the market. This terminology
creates some confusion, however, since the Riksbank neither provides nor absorbs liquidity in the market.
For that reason it is more correct to say that the banking system has a borrowing or deposit requirement at
the Riksbank.
11 The term “repo” is short for repurchase agreement.
12 Strictly speaking, the Riksbank’s repo in this case is a “reverse repo” since the Riksbank first buys securities
and subsequently sells them back. A repo is when a party first sells and then repurchase securities.
13 The repo rate for a repo instrument in the financial markets should not be confused with the Riksbank’s
repo rate, which is in this case the Bank’s key interest rate.
14 In practice, the repo rate is adjusted in connection with the Bank’s pre-announced monetary policy
meetings, which as a rule are held eight times a year. Extra meetings may be called, as was the case when
the repo rate was cut after the terrorist attack in New York on 11 September 2001.

ECONOMIC REVIEW 2/2005 61

 If the banking system instead has a deposit requirement the Riksbank
issues certificates. A Riksbank certificate is a debt instrument that repre-
sents a short-term claim on the Riksbank. The Riksbank sells these certifi-
cates to banks for a period of one week. When the certificates mature, the
Riksbank repays the funds plus interest – the repo rate – to the banks.15
Whether the banking The banking system as a whole currently has a borrowing require-
system needs to borrow
ment at the Riksbank, which is why the description will focus on the mon-
or deposit funds at the
Riksbank has no etary policy repo. Whether the banking system needs to borrow or depo-
significance for the sit funds at the Riksbank has no significance, however, for the Riksbank’s
ability to steer interest
rates. capability to steer interest rates.
The terms and conditions of the repo (or certificate issue) are an-
nounced every Tuesday at 9.30 a.m., covering the type of transaction
(monetary policy repo or certificate issue), maturity, repo rate, and the
minimum and maximum bids. The process is carried out in the form of an
auction whereby the banks notify the Riksbank of how much they need
to borrow. There is no obligation to submit a bid, however.
The banks must tender their bids to the Riksbank before 9.45 a.m.
An allotment is then made according to a percentage share that is calcu-
lated on the basis of the Riksbank’s intended size of the repo and its pro-
portion of the banks’ total bid volume. If, for example, the intended size
of the repo is 50 per cent of the total bid volume, each bank will be able
to borrow 50 per cent of its tendered bid. If the banks’ bids fall short of
the intended size the Riksbank fine-tunes the borrowing requirement.
The Riksbank announces the result of the repo at 10.00 a.m. Figure 6
shows the different steps involved in the implementation of a repo trans-
action. The figure also shows the steps in a certificate issue.

Figure 6. Schedule for the Riksbank’s monetary policy repo or issue of

certificates

The Riksbank
announces a monetary
policy repo or
certificate at 9.30 a.m

The banks tender

their bids at
9.45 a.m at the latest

REPO
The Riksbank The Riksbank sells
The Riksbank buys
annonunces the allot- securities and receives
securities and transfers
ment at 10.00 a.m the funds plus interest
funds to the banks
(the banks borrow (the banks pay back
from the Riksbank) their loans)

Monday Tuesday Wednesday Thursday Friday Saturday Sunday Monday Tuesday Wednesday

CERTIFICATES The Certificates mature

The Riksbank issues (the Riksbank pays back
certificates the loan plus interest)
(the Riksbank borrows
from the banks)

15 From July 1994 to May 1997 the Riksbank issued certificates as the banking system as a whole had a
deposit requirement at the Riksbank. Since then the banking system has had a borrowing requirement.

62 ECONOMIC REVIEW 2/2005

 STEP 3. IMPLEMENTATION OF THE FINE-TUNING OPERATIONS

The banking system’s actual daily borrowing or deposit requirement at the

Riksbank may differ from the Bank's forecast for the average requirement
over the week. That means that the banking system may need to borrow
or deposit funds through the standing facilities.
Since the Riksbank wants a stable overnight rate, the Bank therefore
carries out fine-tuning operations.
Those banks that have a borrowing or deposit requirement at the If there are no matching
positions between the
end of the day, and that have not managed to resolve this in the over- banks the Riksbank
night market, will call the Riksbank after 4.20 p.m. to ask whether the performs a fine-tuning
Bank is offering fine-tuning. The Riksbank has details of both individual operation.

banks’ account balances in RIX and of the banking system’s total position
in relation to the Riksbank. If the requested amount can be matched by
another bank the Riksbank asks the enquiring bank to contact other
banks. If there are no matching positions at the other banks the Riksbank
performs a fine-tuning operation equal to the requested amount or parts
thereof with the enquiring bank.
If, for example, the banking system as a whole has a borrowing re-
quirement of 100 and the Riksbank is contacted by a bank with a borrow-
ing requirement of 150, the Riksbank will only perform fine-tuning opera-
tions for 100. That is because a different bank (or several banks between
them) needs to deposit 50, and the banks are thereby expected to bal-
ance this out in the overnight market.
The Riksbank performs fine-tuning operations between 4.20 p.m.
and 4.40 p.m. as it is not until 4.20 p.m. that the Riksbank has full details
of the banking system's borrowing or deposit requirement.16

Simple, market-oriented operational framework

The Riksbank’s operational framework has a relatively simple design and is
very similar to that employed by other central banks.
It is reasonable to ask, of course, whether it is possible to simplify the Since the Riksbank
strives for a market-
framework further. It is likely, for example, that an even narrower interest
oriented operational
rate corridor would be able to achieve a stable overnight rate. The ques- framework, the current
tion, though, is how narrow the corridor can become before the shortest- solution which
evidently works well
term market, that is the overnight market, ceases to function as the incen- was the evident choice.
tives for the banks to borrow and deposit funds with each other disappear.
In such a situation, the banks will decide to borrow and deposit funds at
the Riksbank only. Since the Riksbank strives for a market-oriented opera-
tional framework, alternative solutions have been rejected in favour of the
current framework, which evidently works well.

16 The banks can return banknotes up to this time.

ECONOMIC REVIEW 2/2005 63

 References
Daltung, S. & Ericson, M., (2004), ”Cash-supply efficiency”, Sveriges
Riksbank Economic Review, no. 3.

Ernhagen, T., Vesterlund, M. & Viotti, S., (2002), “Central banks’ equity
needs”, Sveriges Riksbank Economic Review, no. 2.

Mitlid, K. & Vesterlund, M., (2001), “Steering interest rates in monetary

policy – how does it work?”, Sveriges Riksbank Economic Review,
no. 1.

Sveriges Riksbank, (2004a), The Swedish Financial Market 2004, chapter

entitled “The financial infrastructure”.

Sveriges Riksbank, (2004b), Annual Report 2003, section entitled “Cash

management” under “The Riksbank’s methods of working”.

Viotti, S., (2004), “Swedish Monetary Policy”, Sveriges Riksbank

Economic Review, no. 2.

64 ECONOMIC REVIEW 2/2005