Predicting Bank Interests When Monetary Rates Are Close to Zero

Abstract

Monetary policies, either actual or perceived, cause changes in monetary interest rates. These changes impact the economy through financial institutions, which react to changes in the monetary rates with changes in their administered rates, on both deposits and lendings. The dynamics of administered bank interest rates in response to changes in money market rates is essential to examine the impact of monetary policies on the economy. Chong et al. (2006) proposed an error correction model to study such impact, using data previous to the recent financial crisis. In this paper we examine the validity of the model in the recent time period, characterized by very low monetary rates. The current state of close-to-zero monetary rates is of particular relevance, as it has never been studied before. Our main contribution is a novel, more parsimonious, model and a predictive performance assessment methodology, which allows comparing it with the error correction model.

Dynamic hierarchical models for monetary transmission

“… analysed and extended the ECM (proposed, among others, by for the analysis of the monetary transmission mechanism), by deriving an alternative one‐equation model. More precisely, they assumed that bank interest rates depend on their previous level, to allow for a slow and partial reaction of bank rates to monetary rates changes.…”

“… proposed a model that, differently from , explains the bank rates dynamics as a function of monetary rates and exogenous variables. More precisely, he established a relationship between lending rates, monetary rates, an autoregressive component and the spread between yields on government bonds and 10‐year swap rates.…”

“…While both concentrate on the changes in interest rates on loans due to monetary rates or macroeconomic factors, they still do not account for time‐dependent parameters and cross‐country correlations and, therefore, they need to introduce time‐windows and dummy variables in order to consider changes in time. In this paper, we overcome this issue by introducing dynamic models, which not only allow to derive time‐varying relationships without imposing ex post dummies, but also enable the prediction of future values.…”

“…The effects of the previous changes on the monetary policy transmission have been partially investigated. In particular, the current state of close‐to‐zero interest rates has been analysed, among others, by the studies of : they investigated the macroeconomic impacts of monetary rates at the zero lower bound by looking at the real borrowing costs on the medium and long term. However, they do not provide a dynamic modeling as well as they concentrate on one country at a time without looking at the cross‐sectional dimension: but the sovereign debt crisis has increased the divergence of financial fundamentals in Eurozone countries, making the transmission of the monetary impulse less uniform (eg, ).…”