Ninth IFC Conference on “Are post-crisis statistical initiatives completed?” Basel, 30-31 August 2018 Evaluation of the transmission of the monetary policy interest rate to the market interest rates considering agents expectations 1 Deicy Cristiano-Botia, Eliana Gonzalez-Molano and Carlos Huertas-Campos, Bank of the Republic, Colombia 1 This paper was prepared for the meeting. The views expressed are those of the authors and do not necessarily reflect the views of the BIS, the IFC or the central banks and other institutions represented at the meeting. Evaluation of the transmission of the monetary policy interest rate to the market interest rates considering agents expectations Deicy Cristiano-Botia, Eliana Gonzalez-Molano, Carlos Huertas-Campos1 Abstract Alternative economic models are used to determine whether policy interest rate expectations and unanticipated changes in the reference interest rate affect saving and credit interest rates. We found empirical evidence that policy surprises have predict power to set passive and active interest rates. Similarly, results show that to fix their interest rate financial entities take into account their expectations about policy rate. On the other hand, we found evidence of changes in deposits rates in advance of the announcement of the monetary authority and no significant change on the day of the announcement and the day after the change. Keywords: Expectations, Monetary Policy, Interest Rates and Transmission Mechanism. JEL classification: D84, E43, E52, E58 1 [email protected], [email protected], [email protected]. Contents Introduction ............................................................................................................................................................................ 2 Literature review ................................................................................................................................................................... 3 Estimation of the impact of unanticipated shocks in the policy rate on market interest rates ........... 5 The effect of unanticipated monetary policy shocks on the market interest rates……………………6 Unanticipated monetary shocks estimated as the average of short-run expectations…..…………9 Estimation of the effect of the changes in the policy rate through time.…………………………….… 10 Conclusions ........................................................................................................................................................................... 12 References ............................................................................................................................................................................12 1. Introduction A way to evaluate the degree of transmission of changes in the monetary policy interest rate to market interest rates is to measure it after the decision of the Central Bank. I.e., calculating how much has changed a specific interest rate once the Board of Directos make a policy announcement. This methodology does not consider the effects of the expectations of agents on the transmission. For example, the market can anticipate and partially incorporate the changes in the policy rate to the rates of interest of the economy, and therefore, the transmission would be underestimated. This is important, since in theory, both not anticipated and anticipated changes in the policy rate by financial institutions have effects on the setting of market interest rates. In this context, this document analyzes the transmission of changes in the monetary policy interest rate on the 90-day deposit rate and the interest rates for credits for both ordinary and preferential loans, considering the expectations of agents on future monetary policy decisions. These expectations are based on the information available each period and the agents forecast ability. Empirical analysis comprises three exercises. Firstly, we evaluate the effect that has the unanticipated component of changes in the policy rate to market rates (Vargas et al (2012)). This component is defined as the forecasting error that agents make to project changes in the policy rate using all available information. Second, we present a model under the conditional expectations hypothesis, in which, a medium-term interest rate is defined as the average of the expected short term rates for all periods until maturity. Finally, an analysis of the behavior of short-term interest rates is made considering daily data and taking into account the time intervals defined in Roley and Sellon (1995). To this end, we evaluate the prospective or anticipated effect and the immediate effect of the changes in the policy rate decomposing the estimation in three time periods: a day previous to the announcement, the day of the announcement and the day Post-announcement. This document consists of four sections and the first is this introduction. Section two contains a review of literature and section three explains the econometric models and present estimation results and the final section concludes. 2. Literature review According to Loayza and Schmidt-Hebbel (2002) monetary policy rules that use central banks evaluate its efficiency and optimality mainly through four channels of transmission of monetary policy: the interest rate channel, the channel of asset prices, the exchange rate channel and credit channel. These channels affect the macroeconomic variables in different speed and intensity. Alternatively, the literature identifies the expectations channel, which considers the intertemporal effects associated with the projections of the stance of the Monetary Authority and the present and future behavior of the main variables of the economy. In this way, the beliefs of agents on the shocks and the expected behavior of the main macroeconomic variables affect the effectiveness of the transmission. Similarly, effectiveness also depends on the credibility of the Central Bank and the agents reaction to future policy announcements. To the extent that the credibility of the Central Bank and other institutions is high, the expectations channel has a greater role given that the formation of expectations will be in line with the economic policy measures. In theory, long-term rates can be defined as the average of the expected interest rates of short term until the maturity plus a risk premium. Therefore, it is important to know the expectations of agents on future changes in the policty rate. Faced with this situation, Ellingsen & Söderström (2001) argue that monetary policy actions respond to new and private information, as well as changes in the preferences of the central bank in terms of the stabilization of the output and inflation. Thus, a forecast of the policy rate must include all these variables. One of the first analysis of the response of interest rates before the FED reference rate changes was made by Cook and Hahn (1989), who analyzed the daily relationship between the policy rate and the treasure bonds rates with maturities from 3 months up to 20 years. The authors analyzed for the 70's the movement of the interest rates of the Treasury bonds in the days close to the FED announcement (two days prior to each ad, the day of the announcement and the two days following the ads). They found that the market requires at least one day after the announcement of the FED to consider that the change is carried out. During this period the response of short-term rates was strong, moderate for the mid-term and weak for the long term (being significant for all maturities). Likewise, to analyze the relevance of the theory of expectations, the authors found a strong influence of the expectations on the movements in the daily market rates at the different maturities. Roley and Sellon (1995) studied the response of the long-term rates taking into account the tendency of the market to anticipate monetary policy actions. They found that these forecasts influence the transmission of changes in the policy rates to long-term interest rates. As the authors says, financial institutions have incentives to match the profitability of its portfolio to different maturities. Therefore, they include and adjust their expectations on long-term interest rates, considering the expected future changes in the short-term rates. As an approach of future long-term interest rates, the authors build an average rate from rates of short-term futures. They warn that the response in the long term rates can be inverse to that described by the monetary traditional view, since it depends not only on the expectations of policy rate, but also in the expected persistence of this. In this regard, Roley and Sellon make one caveat to mention that the magnitude of the expected response may vary depending on the perception that agents have on the phase of the economic cycle in which the economy is currently. Thus, surprising policy announcements (which do not correspond to the perceived phase of the economic cycle) will generate a greater response in rates since agents should adjust their investments for short or long term depending on the expected persistence. Kuttner (2001) estimated for United States (between June 1989 and February 2000) a uniform and inferior interest rates response with respect to that found by Cook and Hahn, using the same methodology but with information from the federal funds futures market of the United States (as proposed by Roley and Sellon (1995)). The author suggests that the difference is in comparing changes in rates expected and