Short-term Real Interest Rate Research Articles

Real interest rate volatility in the Pakistani economy: A regime switching approach

This paper assesses the volatility of short term real interest rates in Pakistan using the Markov switching model and drawing on monthly data from January 1964 to March 2016. This model holds that if a random walk pattern is not visible in the real interest rate series, fluctuations are temporary and the interest rate will eventually converge around the mean value. The results reveal that real interest rates in Pakistan have exhibited high volatility since 1973 due to high budget deficits and other sources of instability in the economy.

Measuring the natural rate of interest: International trends and determinants

U.S. estimates of the natural rate of interest – the real short-term interest rate that would prevail absent transitory disturbances – have declined dramatically since the start of the global financial crisis. For example, estimates using the Laubach–Williams (2003) model indicate the natural rate in the United States fell to close to zero during the crisis and has remained there into 2016. Explanations for this decline include shifts in demographics, a slowdown in trend productivity growth, and global factors affecting real interest rates. This paper applies the Laubach–Williams methodology to the United States and three other advanced economies – Canada, the Euro Area, and the United Kingdom. We find that large declines in trend GDP growth and natural rates of interest have occurred over the past 25years in all four economies. These country-by-country estimates are found to display a substantial amount of comovement over time, suggesting an important role for global factors in shaping trend growth and natural rates of interest.

Macroeconomic linkages and international shock transmissions in East Asia: A global vector autoregressive approach

AbstractThe growing interdependency among East Asian countries means that there is concern not only on the way their macroeconomic variables are linked across borders, but also on the way shocks are transmitted as a consequence. This paper investigates the effect of macroeconomic linkages on international shock transmissions in selected East Asian countries. Global Vector Autoregressive model (GVAR) is used on the quarterly data of real output, inflation, equity prices, exchange rates, and short-term interest rate over the period 1979Q2–2013Q1. The result generally shows that the focus countries are more linked to global economy through equity markets, real output, and exchange rates, signifying more tendencies for contagion effects in the same way. On the other hand, result from the dynamic analysis, shows that China contributes highest shock transmission in the real sector, whereas US is the highest in the equity market. For the exchange rate; within-regional shock transmission is found to be highest. T...

European and global financial integration: some panel evidence of the convergence of interest rates

This paper seeks to contribute to the literature on financial integration using panel estimates to test beta- and sigma-convergence across the European Union countries’ interest rates and towards two specific benchmarks — the German and US rates — covering the time interval between 1999 and 2014 and taking into account the recent international financial crisis. The findings point to the existence of a process of convergence of interest rates and this process may be considered as part of the global process of integration. Furthermore, there is evidence of convergence to the chosen benchmarks, in particular of short-term real interest rates; the speed of this convergence towards the German rates clearly increased in the EU as a response to the financial crisis. Keywords: financial integration, banking market, European interest rates, beta-convergence, sigma-convergence, panel data estimates. JEL Classification: C2, E4, F3, G1, G2

Measuring the Natural Rate of Interest: International Trends and Determinants

U.S. estimates of the natural rate of interest?the real short-term interest rate that would prevail absent transitory disturbances?have declined dramatically since the start of the global financial crisis. For example, estimates using the Laubach-Williams (2003) model indicate the natural rate in the United States fell to close to zero during the crisis and has remained there through the end of 2015. Explanations for this decline include shifts in demographics, a slowdown in trend productivity growth, and global factors affecting real interest rates. This paper applies the Laubach-Williams methodology to the United States and three other advanced economies?Canada, the Euro Area, and the United Kingdom. We find that large declines in trend GDP growth and natural rates of interest have occurred over the past 25 years in all four economies. These country-by-country estimates are found to display a substantial amount of comovement over time, suggesting an important role for global factors in shaping trend growth and natural rates of interest.

Measuring the Natural Rate of Interest: International Trends and Determinants

U.S. estimates of the natural rate of interest – the real short-term interest rate that would prevail absent transitory disturbances – have declined dramatically since the start of the global financial crisis. For example, estimates using the Laubach-Williams (2003) model indicate the natural rate in the United States fell to close to zero during the crisis and has remained there through the end of 2015. Explanations for this decline include shifts in demographics, a slowdown in trend productivity growth, and global factors affecting real interest rates. This paper applies the Laubach-Williams methodology to the United States and three other advanced economies – Canada, the Euro Area, and the United Kingdom. We find that large declines in trend GDP growth and natural rates of interest have occurred over the past 25 years in all four economies. These country-by-country estimates are found to display a substantial amount of comovement over time, suggesting an important role for global factors in shaping trend growth and natural rates of interest.

Asset allocation and monetary policy: Evidence from the eurozone

The eurozone has a single short-term nominal interest rate, but monetary policy conditions measured by real short-term interest rates varied substantially across countries in the period 2003–2010. We use this cross-country variation in the (local) tightness of monetary policy to examine its influence on equity and money market flows. In line with a powerful risk-shifting channel, we find that fund investors in countries with decreased real interest rates shift their portfolio investment out of the money market and into the riskier equity market, causing significant equity price inflation in countries where investment home bias is the strongest.

What Can the Data Tell Us About the Equilibrium Real Interest Rate?

The equilibrium real interest rate (r*) is the short-term real interest rate that, in the long run, is consistent with aggregate production at potential and stable inflation. Estimation of r* faces considerable econometric and empirical challenges. On the econometric front, classical inference confronts the pile-up problem. Empirically, the co-movement of output, inflation, unemployment, and real interest rates is too weak to yield precise estimates of r*. These challenges are addressed by applying Bayesian methods and examining the role of several demand shifters, including asset prices, fiscal policy, and credit conditions. We find that the data provide relatively little information on the r* data-generating process, as the posterior distribution of this process lies very close to its prior. This result contrasts sharply with those for the trend growth or natural rate of unemployment processes. Second, credit spreads are very important for the estimated links between output and interest rates and hence for estimates of r*. Estimates of r* that account for this range of considerations are more stable than other estimates, with r* at the end of 2014 equal to approximately 1-1/4 percent.

What Can the Data Tell Us About the Equilibrium Real Interest Rate?

The equilibrium real interest rate (r*) is the short-term real interest rate that, in the long run, is consistent with aggregate production at potential and stable inflation. Estimation of r* faces considerable econometric and empirical challenges. On the econometric front, classical inference confronts the “pile-up” problem. Empirically, the co-movement of output, inflation, unemployment, and real interest rates is too weak to yield precise estimates of r*. These challenges are addressed by applying Bayesian methods and examining the role of several “demand shifters”, including asset prices, fiscal policy, and credit conditions. We find that the data provide relatively little information on the r* data-generating process, as the posterior distribution of this process lies very close to its prior. This result contrasts sharply with those for the trend growth or natural rate of unemployment processes. Second, credit spreads are very important for the estimated links between output and interest rates and hence for estimates of r*. Estimates of r* that account for this range of considerations are more stable than other estimates, with r* at the end of 2014 equal to approximately 1-1/4 percent.

Does real interest rate parity really hold? New evidence from G7 countries

The purpose of this study is to understand the fulfillment of the real interest rate parity (RIRP) for G7 countries using panel data on short-term real interest rate differentials (RIRD). Two modern econometric approaches, sharp transition and smooth transition, are employed to examine the dynamic processes of RIRP in the work. More specifically, the novel approaches which specify Carrion-i-Silvestre et al.'s (2005) model and the Fourier function are adopted to re-examine the RIRD. Some major findings are summarized as follows. Firstly, the empirical results are remarkably consistent, even when using distinct numéraire countries or/and using alternative definitions of the real interest rates. Moreover, we obtain results indicating RIRP fulfillment in most cases, whether we adopt the panel or univariate stationarity tests. However, we fail to obtain the strong evidence in favor of RIRP by the Narayan and Popp (2010) unit root test.

Real term structure forecasts of consumption growth

Abstract This paper employs an empirically tractable affine term structure model of real interest rates to examine the predictive ability of the real short-term interest rate and its term spread with a longer-term interest rate to predict future real consumption growth. The estimates of the model provide support of the consumption smoothing hypothesis. The paper shows that the real term structure is spanned by two mean-reverting state variables. The mean-reverting property of these variables can consistently explain the forecasting ability of the short-term real rate and term spread to forecast future consumption growth rate, over different horizons ahead. Although the risks associated with changes in these variables are both priced in the market, they are not volatile enough to obscure the information of the real term structure about future real consumption growth.

Nonlinear interest rate effects of global oil price changes: the comparison of net oil-consuming and net oil-producing countries

In this article, we test nonlinear causality between global oil price (OP) changes and short-term real interest rate (IR) in large net oil-consuming and net oil-producing countries. Applying nonlinear nonparametric Hiemstra–Jones model and nonlinear parametric Mackey–Glass model, we find no evidence to suggest that potential direct effects of global OP changes on short-term IR are nonlinear in net oil-consuming countries. In contrast, we find such effects to be nonlinear and asymmetric in net oil-producing countries.

The change in real interest rate persistence in OECD countries: evidence from modified panel ratio tests

This study examines whether real interest rates exhibit changes in persistence for a panel of Organization of Economic Cooperation and Development countries. The findings show that for long-term real interest rates there are changes in persistence from I(0) to I(1). For short-term real interest rates, the results display the absence of changes in persistence, while under cross-sectional dependence there is only weak evidence of changes in persistence from I(1) to I(0). The evidence of changes in persistence when the direction is considered unknown is even weaker.

The bank lending channel and monetary policy rules for Eurozone banks: further extensions

AbstractThe monetary authorities affect macroeconomic activity through various channels of influence. This paper examines the bank lending channel, which considers how central bank actions affect the loan supply through its main indicator of policy, the real short-term interest rate. This paper employs the endogenously determined target interest rate, emanating from the European Central Bank’s monetary policy rule, to examine the operation of the bank lending channel. Furthermore, it examines whether different bank-specific characteristics affect how Eurozone banks react to monetary shocks. That is, do sounder banks react more to the monetary policy rule than less-sound banks? The paper finds evidence of an active and statistically and economically significant bank lending channel for the Eurozone between 2000 and 2009.

Revisiting the tale of two interest rates with endogenous asset market segmentation

We develop a monetary model that is unique in its ability to deliver a negative correlation between aggregate consumption growth and short-term real interest rates consistent with U.S. data. The essential ingredient to this success is endogenous asset market segmentation permitting the extent of household participation in asset markets to vary smoothly with changes in aggregate conditions. Households in our model incur fixed transactions costs when exchanging bonds and money and, as a result, carry money balances in excess of current spending to limit the frequency of such trades. While we impose no stickiness at the microeconomic level in either prices or portfolio adjustment, our model drives gradual adjustment in the aggregate price level following a monetary shock and thus persistent non-neutralities. In our model, households can alter the timing of their trading activities in response to changes in both individual and aggregate states. We show that this added flexibility relative to fixed segmentation models can substantially reinforce the sluggishness in aggregate price adjustment following a monetary shock, and it can transform dramatic, transitory changes in real and nominal interest rates into more moderate and persistent liquidity effects. When we extend our setting to consider production, we find that small changes in household participation rates add substantial persistence to movements in inflation, and they deliver persistence in real interest rates that is otherwise absent. These changes are also critically important to our model's success in reproducing the empirical correlation between aggregate consumption growth and real interest rates; when they are suppressed, the success is lost.

Forecasting Surrender Rates Using Elliptical Copulas and Financial Variables

A multistage stochastic model to forecast surrender rates for life insurance and pension plans is proposed. Surrender rates are forecasted by means of Monte Carlo simulation after a sequence of GLM, ARMA-GARCH, and copula fitting is executed. The model is illustrated by applying it to age-specific time series of surrender rates derived from pension plans with annuity payments of a Brazilian insurer. In the GLM process, the only macroeconomic variable used as an explanatory variable is the Brazilian real short-term interest rate. The advantage of such a variable is that we can take future market expectation through the current term structure of interest rates. The GLM residuals of each age/gender group are then modeled by ARMA-GARCH processes to generate i.i.d. residuals. The dependence among these residuals is then modeled by multivariate Gaussian and Student's t copulas. To produce a conditional forecast on a stock market index, in our application we used the residuals of an ARMA-GARCH model fitted to the Brazilian stock market index (Ibovespa) returns, which generates one of the marginal distributions used in the dependence modeling through copulas. This strategy is adopted to explain the high and uncommon surrender rates observed during the recent economic crisis. After applying known simulation methods for elliptical copulas, we proceeded backwards to obtain the forecasted distributions of surrender rates by application, in the sequel, of ARMA-GARCH and GLM models. Additionally, our approach produced an algorithm able to simulate multivariate elliptical copulas conditioned on a marginal distribution. Using this algorithm, surrender rates can be simulated conditioned on stock index residuals (in our case, the residuals of the Ibovespa returns), which allows insurers and pension funds to simulate future surrender rates assuming a financial stress scenario with no need to predict the stock market index.

Revisiting the Interaction between the Nigerian Residential Property Market and the Macroeconomy

Changes in real Gross Domestic Product, changing relativities of exchange rates, as well as inflation rates and short-term interest rates fluctuations exert profound impacts on the bulk of any country’s tangible capital and vice-versa. This paper employs a vector autoregressive (VAR) model to examine the interaction between the Nigerian residential property market - using returns from direct residential property as proxy - and the macroeconomy. First, in estimating a parsimonious VAR model, we applied Augmented Dickney Fuller (ADF) test to detect the presence of unit roots (non-stationary) within the variables that enter the model. Secondly, a multivariate information criteria technique is used in selecting the appropriate lag lengths for the variables to be included in each equation so as not to introduce multicollinearity problem and specification errors. The results of the forecast error variance within the VAR model suggest that macroeconomic shocks explain 28% of the variation in residential property rents and that unexplained variation in the behaviour of residential rents may reflect the explanatory power of property market indicators (as varied as yield, vacancy rates and new construction) rather than macroeconomic variables. Furthermore, responses of residential property rents to shocks in real GDP, exchange rates and short-term interest rates reflect the fact that rents from direct residential property and by extension, the market for residential property adjust slowly to changes in macroeconomic events in Nigeria. On this basis, we hypothesise that this relatively slow adjustment will creates arbitrage profits for parties operating within the Nigerian residential property market to exploit.

An exploratory inquiry into the impact of budget deficits on the nominal interest rate yield on Moody's Aaa-rated corporate bonds, 1973–2012

This exploratory empirical article provides recent evidence on the impact of the US federal budget deficit on the nominal interest rate yield on Moody's Aaa-rated long-term corporate bonds. The study is couched within a loanable funds model that includes an ex ante real short-term real interest rate yield, the monetary base, expected inflation and the change in per capita real GDP. Using data for the period 1973–2012, which time frame includes ‘quantitative easing’ monetary policies in the US, autoregressive two-stage least squares estimation reveals the preliminary finding that the federal budget deficit, expressed as a per cent of GDP, has exercised a positive and statistically significant impact on the nominal interest rate yield on Moody's Aaa-rated long-term corporate bonds, even after allowing for ‘quantifying easing’ and other factors.

Central bank independence and financial stability: A tale of perfect harmony?

In this paper we show that the degree of central bank independence influences the optimal choice of monetary policy strategy during potentially unsustainable asset price booms. We assume that central bankers have to choose between a policy that preemptively raises short-term real interest rates in the boom phase to prevent the build-up of a financial market crisis scenario and the cleaning-up strategy that ignores its impact on the likelihood of a future crisis. We find that the more independent central bankers are, the more likely it is that they refrain from implementing preemptive monetary tightening to maintain financial stability. These results stand in sharp contrast with the seemingly predominant view that central bank independence fosters financial stability. The intuition underlying these results is that a preemptive interest rate hike gives rise to, among other things, a lower inflation rate in the boom period. Whether this disinflation creates additional costs or benefits depends on the degree of central bank independence. It can benefit dependent central bankers who otherwise would suffer from a higher inflation bias; however, for independent central bankers, this disinflation leads to an undesirable undershooting of their inflation target.

How Did the Financial Crisis ImpactRetirees’ Safe Withdrawal Rate? A Markets-Based Answer

Individuals retiring in the aftermath of the financial crisis face an unprecedented market environment. Accommodative monetary policy and below-trend economic growth present retirees with historically low interest rates and the longest period of negative real short-term interest rates since the Great Depression. The result is likely a period of belowaverage, modest total portfolio returns that present a particular challenge to retirees. Most studies of safe retirement withdrawal rates have concluded that a 4% initial withdrawal adjusted for inflation over subsequent years provides a reasonable margin of safety over 30 years. However, these studies generally use historical analysis or forward-looking return analysis based on long-term return estimates and/or average realized returns. Because of this approach, an extended period of low nominal rates and negative real rates is not captured in traditional methodologies; therefore, these methodologies run the risk of overstating safe withdrawal rates. As an alternative, this article presents a market-based methodology for determining appropriate spending policy. Simulation analyses along with market-implied capital market assumptions (CMAs) are used to estimate feasible distribution rates for various portfolios over the next 30 years. The results imply that an initial withdrawal rate of 4% is unlikely to provide investors with a sufficient margin of safety. Instead, lowering initial withdrawal rates to 3.5% is likely to prove prudent.