Interest Rate Reaction Research Articles

Comparing Monetary Policy Reaction Functions: ECB versus Bundesbank

This paper compares the ECB’s conduct of monetary policy with that of the Bundesbank. Estimated monetary policy reaction functions for the Bundesbank (1979:4-1998:12) and the European Central Bank (1999:1-2004:5) show that, while the ECB and the Bundesbank react similarly to expected inflation, the ECB reacts significantly stronger to the output gap. Theoretical considerations suggest that this stronger response to the output gap may rather be due to a higher interest rate sensitivity of the German output gap than to a higher weight given to output stabilisation by the ECB. Counterfactual simulations based on the estimated interest rate reaction functions suggest that German interest rates would not have been lower under a hypothetical Bundesbank regime after 1999. However, this conclusion crucially depends on the assumption of an unchanged long-run real interest rate for the EMU period. Adjusting the Bundesbank reaction function for the lower long-run real interest rate estimated for the ECB regime reverses this conclusion.

Term-Structure Factor Shifts and Economic News

For this article, daily changes in pure discount yields on U.S. risk-free securities were fit to a theoretically robust term-structure model to derive a set of orthogonal factors measuring the level, slope, and curvature of the yield curve. Changes in these factors at the release of unexpected economic news are reported. This methodology explicitly allows for commonalities in responses in the universe of spot rates, thus painting a rich picture of interest rate reactions to new information. The results have important implications for hedging volatility risk or seeking to profit from predicting volatility in bond prices.

Interest Rate Reaction Functions for the Euro Area Evidence from Panel Data Analysis

As of today, estimating interest rate reaction functions for the Euro Area is hampered by the short time span since the conduct of a single monetary policy. In this paper we circumvent the common use of aggregated data before 1999 by estimating interest rate reaction functions based on a panel including actual EMU Member States. We find that exploiting the cross-section dimen- sion of a multi-country panel and accounting for cross-country heterogeneity in advance of the single monetary policy pays off with regard to the estimated reaction functions' ability to describe actual interest rate dynamics. We retrieve a panel reaction function which is demonstrated to be a valuable tool for evaluating episodes of monetary policy since 1999.

Price Dividend Models, Expectations Formation, and Monetary Policy

This paper applies the Campbell-Shiller (1988) methodology to estimate a price dividend model with volatility and inflation risk, extending existing models in this field. The model fits the data well over the period 1979-2002 for the Euro Area, but less so for the U.S. The latter is interpreted as reflecting fads and is borne out by a decomposition of the price dividend ratio into a fundamental and bubble part. Finally, it is shown that deviations from fundamentals enter significantly in the Fed's interest rate reaction function but at the cost of destabilising monetary policy. Alternatively, in case that Fed policy remained stable, there was not much of attention to asset bubbles. For the Euro Area, historically, the reaction function does not appear to react much to asset prices.

Interest Rate Reaction Functions and the Taylor Rule in the Euro Area

Traditional Taylor rules, which are estimated using a level specification linking the short-term interest rate to inflation and the output gap, are unstable when estimated on euro area data and forecast poorly out of sample. We present an alternative reaction function which takes the non-stationarity of the data into account. The estimated interest rate rule is stable and forecasts well. In contrast to the traditional Taylor rule, we find a significant role for the long rate, which we argue reflects shifts in the public's perception of the long-run inflation objective.

Does Institutional Change Really Matter? Inflation Targets, Central Bank Reform and Interest Rate Policy in the OECD Countries

We estimate forward–looking interest rate reaction functions for the G3 and some inflation targeters. Shifts in the conduct of monetary policy are detected for the USA and Japan. In contrast with the existing literature, we show that these countries only shifted to policies consistent with an implicit inflation–targeting regime in the 1990s. Inflation targets and central bank reforms in Sweden, the UK, Canada and New Zealand only led in some cases to changes in policy responses, and changes in policy pre–date the introduction of targets. We challenge the one–model–fits–all approach towards monetary policy that permeates much of the current literature.

From Dornbusch to Murphy: Stylized Monetary Dynamics of a Contemporary Macroeconometric Model

Newer applied macroeconometric models have adopted a mixture of paradigms to capture at least the major differences between the behavior of financial markets and markets for commodities and for factors. Thus, in the Murphy Model of the Australian macroeconomy (MM), rational expectations and very rapid adjustment are assumed to apply in markets for financial assets, but frictions and departures from rationality manifest themselves in the short-term behavior of other markets. A popular story for the reaction of exchange and interest rates to monetary shocks is provided by Dornbusch's 1976 overshooting exchange rate model (DBM). The rational-expectations version of this archetypal model underpins MM, yet the dynamic adjustment paths of variables in MM differ markedly from those in DBM. A leading case in point is the exchange rate which in MM actually undershoots its new equilibrium value after the injection of a monetary shock. This paper gives a simplified account of how the differences come about. The emphasis is not so much on theoretical rigor as on providing a convincing practical demonstration. Using the simplest form of DBM as a starting point, it is shown how one can progressively develop a miniature model exhibiting an MM-like response to a monetary shock. The key idea in this development is that aggregate demand does not respond instantaneously to shocks in the macroeconomic environment. The vehicle used to implement the numerical miniature model is a computer spreadsheet. Although the specifics relate to MM, the generics of this development seem likely to be applicable to most models adopting the mixture of paradigms identified above. This conclusion survives the current proclivity to replace Dornbusch's money demand function in the larger models by a policy reaction function in which interest rates are manipulated to control inflation.

Does Institutional Change Really Matter? Inflation Targets, Central Bank Reform and Interest Rate Policy in the OECD Countries

We estimate forward-looking interest-rate reaction functions for the G3 economies and for a group of countries which recently adopted inflation targets. Some significant shifts in the conduct of monetary policy are detected in the G3 countries, especially in the USA and Japan. In contrast with popular wisdom, it is only since the 1990s that policies in these countries begin to look consistent with an inflation-targeting regime. In addition, the introduction of inflation targeting and central bank reforms in countries like Sweden, Canada and New Zealand has not led to major changes in the way in which central banks react to the objectives of economic policy. In all cases changes in policy behaviour pre-date the introduction of inflation targets and central bank reforms. The paper challenges the one-size-fits-all attitude towards modern central bank policymaking which permeates a great deal of the current literature.

Expectations, Learning and the Costs of Disinflation: Experiments using the FRB/US Model

The costs of disinflation are explored using the Board's new sticky-price rational expectations macroeconometric model of the U.S. economy, FRB/US. The model nests both model consistent and `restricted-information rational' expectations. Monetary policy is governed by interest-rate reaction functions of which two are considered: the well-known Taylor rule and another rule that is more aggressive and richer in its specification, estimated using data for the last fifteen years. Agents are required to learn of shifts of the inflation target using linear updating rules. The simulated costs of disinflation are compared with other estimates of sacrifice ratios.

The Choice of Exchange Rate Regime

In the 1990s, UK policy towards the exchange rate shifted from an attempt to be part of an ERM committed to narrow exchange rate bands to a monetary policy where the exchange rate has no explicit role. In particular, during the latter half of 1996 and the beginning of 1997 Sterling appreciated substantially, and yet the Bank of England continued to suggest that interest rates needed to rise to meet inflation targets.1 However, the government has not ruled out the possibility of irrevocably fixing its exchange rate against key European currencies by joining a European Monetary Union. Dramatic shifts in policy towards the exchange rate are not unusual historically.2 These shifts, like recent changes in UK policy, give the impression that governments should either fix the exchange rate or ignore it. Although textbook discussions of exchange rate policy often compare these two extremes, in reality compromise positions are possible and have been pursued in the past. What I shall describe as ‘weak exchange rate targeting’ can be implemented either in the form of wide currency bands,3 or if the exchange rate appears as an argument in an (explicit or implicit) interest rate reaction function.

The Reaction of Exchange Rates and Interest Rates to News Releases

The Reaction of Exchange Rates and Interest Rates to News Releases

The Reaction of Exchange Rates and Interest Rates to News Releases

The Reaction of Exchange Rates and Interest Rates to News Releases

The Reaction of Exchange Rates and Interest Rates to News Releases

This paper examines the response of exchange rates and interest rates—US and foreign—to economic news. The news is associated with the surprise component of the monthly release of six US macroeconomic variables. The results suggest that dollar exchange rates systematically react to news about real economic activity—a surprise of 100 000 on non-farm payroll employment leads to a 0.2% appreciation of the exchange rate. In general, exchange rates do not react systematically to news on inflation. In contrast, US interest rates respond to both types of news, although the response continues to be extremely small, of the order of 1 to 2 basis points. Finally, Japanese interest rates systematically react, but to a very minor extent, to news about US real economic activity, while German rates, in general, do not. © 1997 John Wiley & Sons, Ltd.

The Reaction of Exchange Rates and Interest Rates to News Releases

This paper examines the response of exchange rates and interest rates--U.S. and foreign--to economic news. The news is associated with the surprise component of the monthly release of six U.S. macroeconomic variables. The results suggest that dollar exchange rates systematically react to news about real economic activity--a surprise of 100,000 on nonfarm payroll employment leads to a 0.2 percent appreciation of the exchange rate. In general, exchange rates do not react systematically to news on inflation. By contrast, U.S. interest rates respond to both types of news, although the response continues to be extremely small, on the order of 1 to 2 basis points. Finally, Japanese interest rates systematically react, but to a very minor extent, to news about U.S. real economic activity, while German rates in general do not.

The Reaction of Exchange Rates and Interest Rates to News Releases

This paper examines the response of exchange rates and interest rates--U.S. and foreign--to economic news. The news is associated with the surprise component of the monthly release of six U.S. macroeconomic variables. The results suggest that dollar exchange rates systematically react to news about real economic activity--a surprise of 100,000 on nonfarm payroll employment leads to a 0.2 percent appreciation of the exchange rate. In general, exchange rates do not react systematically to news on inflation. By contrast, U.S. interest rates respond to both types of news, although the response continues to be extremely small, on the order of 1 to 2 basis points. Finally, Japanese interest rates systematically react, but to a very minor extent, to news about U.S. real economic activity, while German rates in general do not.

Does the federal reserve affect asset prices?

Abstract The Federal Reserve is probably one of the institutions most closely monitored by investors. This indicates that investors believe the actions of the Fed have implications for asset prices. To this date, the trading activities of the Fed in the financial markets have not been examined to see how the Fed influences asset prices. Using daily data on open market operations (OMOs) and asset prices, this study fills this void. One finding of the paper is that OMOs Granger-cause both short- and long-term interest rates. Furthermore, the sign of the relationship confirms the existence of the liquidity effect. Given that its trades represent a small portion of the market volume, how the Fed influences bond prices is a puzzle. The only reasonable explanation is that the Fed's trades have high information content. Judging by the impulse response paths, the reaction of interest rates to open market operations is fast. Additionally, it appears that monetary policy has a lasting impact on interest rates.

Exchange Rates and the Role of the Trade Balance Account

The essence of the modern asset‐market approach to the analysis of exchange rate behavior includes the role of the trade balance account. We examine the relationship between exchange rate changes and US trade balance announcements. Statistically significant exchange rate adjustments to these announcements are documented using for the first time the comparison period approach to testing the significance of trade balance announcements on exchange rates. The evidence is consistent with the predictions of the modern asset‐market exchange rate model. There is also evidence that the foreign exchange market is more sensitive to increasing rather than decreasing trade balance deficit announcements. To date, a number of theoretical papers have investigated the possible sources of the exchange rate determination process (see, Dornbusch [1976,1980], Dornbusch and Fisher [1980], Frenkel [1976, 1981], Kouri [1976], and Mussa [1982], among others). There is no consensus on how exchange rates are determined and why they...

Money supply announcements and real interest rates: Evidence from the U.K. index-linked bond market

Current research on the relation between money and asset prices focuses on the reaction of asset prices to money supply announcements. In this paper we use the real interest observed in the U.K. index-linked bond market and the nominal interest rate observed in the nominal bond market to study the reaction of real interest rates and expected inflation to money surprises. We find that monetary surprises have a strong effect on inflationary expectations. We also find some evidence of a positive reaction of long-term real interest rates to the £M3 announcement.

Presidential elections and the Federal Reserve's interest rate reaction function

We examine the political business cycle from the perspective of an interest rate reaction function and then contrast the Federal Reserve's willingness to endure unemployment for the sake of lower inflation with that of the electorate.

The Reaction of Interest Rates to Unanticipated Federal Reserve Actions and Statements, 1977-1984: Implications for the Money Announcement Controversy

Considerable attention has been devoted to the reaction of interest rates, foreign exchange rates, and stock prices to unanticipated money growth revealed by the weekly MI money stock announcement. Numerous articles have attempted to explain why nominal interest rates rise following the announcement of an MI figure higher than expected and fall when an Ml figure is lower than expected. The major controversy in this literature is whether the observed reaction of interest rates reflects changes in the inflation expectations component or in the real rate component of the nominal rate.