Interest Rate Setting Research Articles

Behind Closed Doors: Revealing the ECB’S Decision Rule

This paper aims at discovering the decision rule the Governing Council of the ECB uses to set interest rates. We construct a Taylor rule for each member of the council and for the euro area as a whole, and aggregate the interest rates they produce using several classes of decision-making mechanisms: chairman dominance, bargaining, consensus, voting, and voting with a chairman. We test alternative scenarios in which individual members of the council pursue either a national or a federal objective. We then compare the interest-rate path predicted by each scenario with the observed euro area’s interest rate. We find that scenarios in which all members of the Governing Council are assumed to pursue Euro-area-wide objectives are dominated by scenarios in which decisions are made collectively by a council consisting of members pursuing national objectives. The best-performing scenario is the one in which individual members of the Governing Council follow national objectives, bargain over the interest rate, and their weights are based on their country’s share of the zone’s GDP.

Forecasting monetary policy rules in South Africa

This paper is the first one to: (i) provide in-sample estimates of linear and nonlinear Taylor rules, augmented with an indicator of financial stability, for the case of South Africa, and (ii) analyse the ability of linear and nonlinear monetary policy rule specifications, as well as nonparametric and semiparametric models, to forecast the nominal interest rate setting that describes the South African Reserve Bank’s (SARB) policy decisions. Our results indicate, first, that asset prices are taken into account when setting interest rates; second, that there are nonlinearities in the monetary policy rule; and third, that forecasts constructed from semiparametric models perform particularly well over the inflation targeting regime and that there are gains from semiparametric models in forecasting the interest rates as the forecasting horizon lengthens.

Financial conditions and nonlinearities in the European Central Bank (ECB) reaction function: In-sample and out-of-sample assessment

Our purpose is to investigate how the European Central Bank (ECB) sets interest rates in the context of both linear and nonlinear policy reaction functions. This work contributes to the current debate on central banks having additional objectives over and above control of inflation and output. Three findings emerge. First, the ECB takes financial conditions into account when setting interest rates. Second, amongst Taylor rule models, linear and nonlinear models are empirically indistinguishable within sample, and model specifications with real-time data provide the best description of in-sample ECB interest rate setting behaviour. Third, the 2007–2009 financial crisis witnessed a shift from inflation targeting to output stabilization, and a shift from an asymmetric policy response to financial conditions at high inflation rates to a more symmetric response regardless of the state of inflation. Finally, guidance is provided as regards models for forecasting interest rates in the Eurozone area. Without imposing an a priori choice of the parametric functional form, semiparametric models and autoregressive processes forecast the out-of-sample ECB interest rate setting behaviour better than linear and nonlinear Taylor rule models.

Canadian Interest Rate Setting: The Information Content of Canadian and U.S. Central Bank Communication

We explain Canadian target rate decisions using macroeconomic variables as well as Bank of Canada (BOC) and Federal Reserve (Fed) communication indicators. Econometrically, we employ an ordered probit model of a Taylor rule to explain and predict 60 target rate decisions between 1998 and 2006. We find that communications, and most especially speeches and testimony by Canadian Governing Council members, provide a significant and robust explanation of Canadian target rate decisions. However, prior to the introduction of fixed announcement dates, Canadian communications contained more information on upcoming policy moves. Finally, communications by the U.S. Federal Reserve Bank—which are much more frequent—outperform our Canadian communication indicators in explaining Canadian interest rate decisions.

Canadian Interest Rate Setting: The Information Content of Canadian and U.S. Central Bank Communication

We explain Canadian target rate decisions using macroeconomic variables as well as Bank of Canada and Federal Reserve communication indicators. Econometrically, we employ an ordered probit model of a Taylor rule to explain and predict 60 target rate decisions between 1998 and 2006. We find that communications, especially speeches and testimony by Canadian Governing Council members, provide a significant and robust explanation of Canadian target rate decisions. However, prior to the introduction of fixed announcement dates, Canadian communications contained more information on upcoming policy moves. Finally, communications by the U.S. Federal Reserve Bank—which are much more frequent—outperform our Canadian communication indicators in explaining Canadian interest rate decisions.

Public Attitudes to Monetary Policy and Satisfaction with the Bank

The Bank of England’s success in achieving its monetary policy objectives will depend, in part, on the public’s awareness and understanding of monetary policy. Results from the Bank/GfK NOP survey suggest that public awareness of the policy framework remains high and has changed little over the past year. A greater proportion of respondents to the Bank/GfK NOP survey were satisfied than dissatisfied with the way in which the Bank has set interest rates to meet the inflation target. But the extent of satisfaction has fallen since mid-2010.

Stochastic Optimization for Portfolios Consisting of Corporate Bonds in an Integrated Market and Credit Risk Framework

High credit spreads in 2009 have attracted a lot of interest from investors seeking higher yields outside of government bonds. Investment grade corporate bonds have indeed been a popular investment in 2009. The corporate bond market today is one of the largest and most liquid of the financial markets. Corporate bonds markets can be appealing as they are generally considered safer than stocks and they often provide higher yields and more liquidity than government bonds markets. After the World Financial Crisis central banks set interest rates at their historically low level affecting positively bonds’ prices. The question for a corporate bond portfolio manager is which decisions to take in order to hedge portfolio against volatility of interest rates. Additionally managers have to analyse the factors that affect bonds’ prices volatility and is due to credit risk. For this reasons managers have to implement a risk management framework in order to identify the factor that affect whole portfolio value and finally optimize its value. In an integrated market and risk perspective the future value of a corporate bond portfolio is decomposed into the risk that a bond issued by a firm downgraded by rating agencies and possible drives to default, the correlation between credit events, the risk that changes occur on the average spread of exposures with the same final rating as the firm and the effect of interest rate uncertainty.In chapter 1 we introducing the main types of bonds, analyzing how to valuate non-callable bonds and calculating their yielding and we present factors that affect bond process and price volatility when interest rates changes a bit in a parallel way.In chapter 2 we make an introduction to risk management by referring the risks that affect corporate bond prices. Then we explain the term structure of interest rates and how we can immunize a portfolio of bonds when interest rates changes in a parallel way. Then we introduce a multi-factor model for corporate bonds and present a portfolio immunization model based on factors to protect portfolio value against non-parallel changes of interest rates, introducing the appearance of shape risk.In chapter 3 we added an introduction of credit risk referring the main sources of credit risk in a portfolio of corporate bonds. Then we model credit risk based on a reduced-form approach which defines the default as the instantaneous likelihood of default, called the hazard rate. In chapter 4 we present an integrated market and credit risk framework using scenario generation in order later to optimize a corporate bond portfolio using stochastic programming models. Scenario generation is a tool to model the uncertainty. We develop a model for stochastic interest rates and credit spreads based on the Hull-White algorithm. Interest rates and credit spreads stochasticity based on extended Vasicek model and we produce scenarios of interest rates and credit spreads using trinomial lattice structures which capture the correlation between interest rates and default intensities. Finally we model the correlation between default and migration.In chapter 5 we present the necessity for Conditional Value-at-Risk as a coherent risk measure for corporate bond portfolios. The right risk measure is of paramount importance when we optimize corporate bond portfolios because of tail effects (heavy tails) in the distribution of returns that could result in significant losses and destroy portfolio efficiency. Then we present a linear program for minimizing portfolio risk using CVaR.In chapter 6 we implement portfolio optimization models using stochastic programming in a dynamic aspect. Initially we present an anticipative model where we only take into account stochasticity in future prices without taking recourse actions. Then we present a multistage recourse model where we can take recourse decisions at the preceding time periods based on information we take at discrete time in the future. We assume that there are transaction costs when we buy or sell bonds in order to make models more sophisticated. Finally we analyze one by one the equations of multistage recourse model.

The Information Content of the French and German Government Bond Yield Curves: Why Such Differences?

In this paper, we evaluate the information content of the yield curve as regards future interest rates and inflation in France and Germany. An original data set of long-term zero-coupon interest rates for French and German government bonds was constructed for the period 1980-97. Empirical evidence shows that the German yield curve has a significant information content about the future average change in short-term rates and the future path of inflation. The information content of the French yield curve is much more limited and is only relevant for the average change in short-term rates. We show that the difference between the results obtained for both countries mainly stems from lower variability in German risk premia than in French risk premia.

Sex and Credit: Is There a Gender Bias in Microfinance?

This paper examines the effects of group identity in the credit market. Exploiting the quasirandom assignment of first-time borrowers to loan officers of a large Albanian lender, we test for own-gender bias in the loan officer-borrower match. We find that borrowers pay on average 29 basis points higher interest rates when paired with a loan officer of the other sex. The results indicate the presence of a taste-based rather than a statistical bias, as borrowers’ likelihood of going into arrears is independent of loan officer gender. Ending up with an opposite-sex loan officer also affects demand for credit, with borrowers being 11.5 percent less likely to return for a second loan. The bias is more pronounced when the social distance, as proxied by difference in age between the loan officer and the borrower, increases and when financial market competition declines. This is consistent with theories that predict a tastebased bias to be stronger when the psychological costs of being biased are lower and the discretion in setting interest rates is higher. Taken together, the findings suggest that owngender preferences can have substantial welfare effects.

Did the Rise of CLOs Lead to Riskier Lending?

We investigate whether the securitization of corporate loans affected banks’ lending standards. We find that during the boom years of the CLO business, loans sold to CLOs at the time of their origination underperform matched unsecuritized loans originated by the same bank. This finding is robust to loan- and borrower-specific controls, as well as the lender’s skin in the game. Banks’ use of lax underwriting standards appears to have contributed to the worse performance of the loans they sell to CLOs. We find that banks put less weight on the hard information on borrower risk available to them when they set interest rates on the loans they sell to CLOs, and that they retain less skin in the game on these loans. We also find that the median non-CLO syndicate participant retains a lower stake in securitized loans when compared to loans that are not securitized, suggesting that these investors, like lead banks, expected securitized loans to perform worse.

Bank Heterogeneity and Interest Rate Setting: What Lessons Have We Learned Since Lehman Brothers?

A substantial literature has investigated the role of relationship lending in shielding borrowers from idiosyncratic shocks. Much less is known about how lending relationships and bank-specific characteristics affect the functioning of the credit market in an economy-wide crisis, when banks may find it difficult to perform the role of shock absorbers. We investigate how bank-specific characteristics (size, liquidity, capitalization, funding structure) and the bank-firm relationship have influenced interest rate setting since the collapse of Lehman Brothers. Unlike the existing literature, which has focused chiefly on the amount of credit granted during the crisis, we look at its cost. The data on a large sample of loans from Italian banks to non-financial firms suggest that close lending relationships kept firms more insulated from the financial crisis. Further, spreads increased by less for the customers of well-capitalized, liquid banks and those engaged mainly in traditional lending business.

Interest-Rate Setting at the ECB Following the Financial and Sovereign Debt Crises, in Real-Time

We analyse European Central Bank (ECB) policy by estimating a forward-looking, augmented Taylor rule using expectations data. Specifically, we investigate the impact of the financial and sovereign debt crises on ECB policy. We find the European Overnight Index Average (EONIA) rises when expected economic activity is strong. Regardless of the inflation measure, inflation is not associated with the EONIA. Using a recursive estimation and a Chow test, we identify a policy shift in December 2008. The more generally accepted starting date of the crisis, August 2007, does not correspond to a statistically significant shift in the ECB policy. Using December 2008 for a policy shift, general financial market sentiment, as measured by VSTOXX, is not significant in explaining EONIA movements. The ECB’s response to a shock to economic activity has been more moderate since the crises. However, the EONIA increases as Greek sovereign risk rises, possibly from increasing demand for liquidity by banks.

Probabilistic Interest Rate Setting with a Shadow Board: A Description of the Pilot Project

This study aims to assess the scope for monetary policymakers to aggregate probabilistic interest rate advice. The members of a Shadow Board give probabilistic assessments of the appropriate (target) interest rate for Australia in real time. The pilot project will be running in August, September and October 2011, with the Shadow Board giving advice shortly before each decision by the Reserve Bank of Australia (RBA) Board.

National Representation in Multinational Institutions: The Case of the European Central Bank

Multinational institutions face an important trade-off when hiring personnel. On the one hand, hiring decisions are based, as in most organizations, on a candidate’s professional qualifications. On the other hand, multinational institutions often aim for broad national representation. Reviewing evidence from the European Central Bank, we show that nationality is indeed relevant for both hiring and decision-making. Specifically, we identify various country-specific features that determine national representation in the top management of the ECB. Further, there is evidence for the existence of national networks between adjacent management layers. Finally, monetary policy decisions seem to be linked to national representation in the core business areas of the ECB. Examining a sample of 14 European countries over the period from 1999 to 2008, we estimate Taylor rules for alternative sets of euro area aggregates derived from different weighting schemes of national macroeconomic data. Our results indicate that weights based on national representation in the mid-level management of the ECB's core business areas best describe the central bank's interest-rate setting behavior.

Setting Interest Rates in the Modern Money Era

Financial innovations have reduced banks’ reserve holdings. Some argue the Fed’s ability to set interest rates might be compromised. This concerns arises from a misunderstanding of Fed operations. Regardless of the quantity of reserve balances, the Fed can always set its federal funds rate target. The quantity of reserve balances or the relative size of the Fed’s operations are also unrelated to its influence on interest rates. That banks must settle their customers’ tax liabilities using reserve balances is sufficient for the Fed’s interest rate target to influence other interest rates.

Interest Rate Setting by the Fed, the ECB, the Bank of Japan and the Bank of England Compared

In this paper we compare the policy responsiveness of the Federal Reserve System, the European Central Bank, the Bank of Japan and the Bank of England. At first glance we find substantial differences in the frequency and amplitude of monetary policy decisions. Differences in the actual implementation of monetary policy are, however, less pronounced when seen through the ‘lenses’ of diverse specifications of monetary policy rules – including a variant of the growth rule and a specification accounting for asymmetric preferences. In fact, all four central banks seem to pursue their respective price stability objective. The observed similarities might be due, inter alia, to the fact that they operate in four of the world's largest and most open economies, and are, therefore, subject to relatively similar domestic but also international economic fundamentals.

The Organization of Lending and the Use of Credit Scoring Techniques in Italian Banks: Results of a Sample Survey

This paper examines the results of a survey carried out in 2007 by the Bank of Italy concerning different characteristics of the organization of lending activities. Between 2003 and 2006 the physical distance between the headquarters and the branches increased, the limits to the decision-making process of loan officers were eased, their mobility raised and the use of economic incentives to reward their activity expanded. The huge heterogeneity in organizational structures persists even within relatively homogenous size classes. The diffusion of statistical models to assess credit risk (scoring), accelerated recently particularly among large banks, boosted by the new Basel Capital Accord. Scoring is either very important or determinant in decisions on credit extension while it is rarely influential in setting interest rates, the duration of the credit and the amount and type of collateral required. The survey shows that banks have been progressively adapting their organizational structure in order to incorporate the credit scoring tools into their lending processes.

The Mortgage Crisis: Tipping Points and Trends Underlying the Housing Boom and its Subsequent Bust

In The Mortgage Crisis, a PowerPoint presentation, tipping points and enabling trends are identified which, in the author’s opinion, played key roles leading to the housing boom and the subsequent mortgage crisis, which eventually spread to the entire financial system and the real economy. For example, one of the tipping points was the failure of the bond rating agencies to properly assess risks of default of subprime mortgage loans and mortgage-backed structured notes. Another tipping point was the investment banks’ overleveraged positions in structured notes. Enabling trends include: Greenspan put in the form of setting interest rates too low for too long following the dot.com implosion resulted in unchecked credit expansion; SEC permitted markedly-higher leverage for securities firms in 2004; the political roles of Fannie Mae & Freddie Mac increased risk; globalization of financial markets led to increased risk-taking; building infrastructure for China’s Olympics may have led to the oil price spike and the global economic crisis; and financial models resulted in misaligned incentives for players. Two Tables of Contents, on Charts 2 and 41, enable the reader to focus on selected topics covered in The Mortgage Crisis, including each of the four major tipping points of the crisis and the thirteen enabling trends. The spread of the mortgage crisis to the entire financial market is delineated in Mortgage Crisis led to Credit and Illiquidity Crisis, a sequel by the same author.

Macroeconomic policy in light of the credit crunch: the return of counter-cyclical fiscal policy?

This paper begins by arguing that the 2007/8 credit crunch does not require a fundamental reevaluation of monetary policy. The crunch occurred because regulation was too lax, and we need to develop new and more effective tools of regulatory control. To focus on current account imbalances or mistakes in setting interest rates as a prime cause of the credit crunch is unconvincing, and has the danger of diverting attention away from the need to increase financial regulation. The current recession does require a re-evaluation of the role fiscal policy can play when interest rates hit a zero bound. An expansionary fiscal policy is required because monetary policy-makers are reluctant to promise higher future inflation, and the impact of quantitative easing is likely to be small. Although rising debt may place a limit on how much conventional fiscal policy can do, not all expansionary fiscal measures require additional borrowing. There are two important lessons for the future. First, although monetary policy should remain the primary tool to stabilize the business cycle, the combination of fiscal implementation lags and uncertainty means that some precautionary fiscal action may be appropriate during the early phase of some economic downturns. Second, to play this 'backstop' stabilization role effectively, a policy that results in the government debt-to-GDP ratio declining (albeit gradually and erratically) in normal times seems appropriate.

PARAMETER UNCERTAINTY AND NONLINEAR MONETARY POLICY RULES

Empirical evidence suggests that the instrument rule describing the interest rate–setting behavior of the Federal Reserve is nonlinear. This paper shows that optimal monetary policy under parameter uncertainty can motivate this pattern. If the central bank is uncertain about the slope of the Phillips curve and follows a min–max strategy to formulate policy, the interest rate reacts more strongly to inflation when inflation is further away from target. The reason is that the worst case the central bank takes into account is endogenous and depends on the inflation rate and the output gap. As inflation increases, the worst-case perception of the Phillips curve slope becomes larger, thus requiring a stronger interest rate adjustment. Empirical evidence supports this form of nonlinearity for post-1982 U.S. data.