Monetary Policy and the Determinants of the Money Market Rates in Portugal

Abstract

Interbank money market rates represent the shortest end of the yield curve. In equilibrium they are determined by monetary policy and banks' liquidity and reserve management operations. The central bank pursues interest rate stabilization while targeting long-term economic goals. Its success depends on the perceived commitment and credibility of the monetary policy. Banks are subject to liquidity shocks and minimum reserve requirements constraints. They use interbank money market loans to obtain insurance against liquidity shocks. This paper analyzes the determinants of interbank rates for all maturities in the money market spectrum. We develop a multivariate cointegrated VAR in error correction form, while taking into account the interbank money market institutional features, the reserve requirements regime and the monetary policy operating operational procedures. The model is estimated using real transactions data on the Portuguese interbank money market over a ten years period ending in December 1998. The high frequency data set offers a unique opportunity to analyze the impact of different monetary policy regimes, and the real impact of monetary policy on effective rather than quoted interest rates. We are able to relate predictable short-term patterns of interbank money market rates to the operational framework for monetary policy and to the credibility of central bank commitments. We find interbank money market rates form two blocks moving together: a short-term and a long-term block. The one-week rate - which is anchored to the main refinancing operations - links the two blocks. Interest rates respond to several long run factors. Although each rate is more responsive to its own spread with the target other spreads are also important. Neglecting the effect of other maturities' spreads on the interest rate adjustment misses a richer framework. We can gain additional insight into interest rates dynamics by looking at broader decomposition of the yield curve.