Sources of regime switching in short-term interest rates for Canada

Abstract

The purpose of this study is to identify sources of regime switching in short-term interest rates for Canada. The choice of information variables is based on three well-known hypotheses about interest rates: the expectations hypothesis, the Fisher relationship, and the condition for uncovered interest parity. The empirical framework consists of an autoregressive distributive lag (ADL) model in error-correction form with information spreads and a Markov regime-switching estimation methodology. The models choose interest-rate regimes that are similar in many respects to those found for the USA. The different regimes in Canada are driven by movements in the monetary policy rate, the US short-term rate, and the long-term yield. The monetary policy rate is found to trigger very large changes in the short-term rate, responding one-for-one in the high-variance regime and slightly less in the more ‘normal’ interest-rate regime. Both the US short rate and long-term yield are also found to trigger relatively large changes in short-term rates, but only in the high-variance regime. Inflation, however, is not found to contain additional information about regime switches in interest rates at the short-term horizon.