The Causality Effects of the Federal Reserve's Monetary Policy on U.S. and Eurodollar Interest Rates

Abstract

Previous studies argue that U.S. interest rates will become more sensitive to changes in eurodollar rates as international financial-market integration increases. However, the empirical results of these studies are suspect because they select their subperiods in an ad hoc manner and ignore the different trading hours of the U.S. and London markets.This study adjusts for the markets' different trading hours and uses Goldfeld and Quandt's switching regression technique to show that the causal relation between U.S. CD rates and eurodollar rates is impacted by the Federal Reserve's monetary policy. Because the latest subperiod exhibits uni-directional causality (i.e., U.S. interest rates cause changes in eurodollar rates), the results cast doubt on the implicit assumption made in the literature that interest-rate causality is only affected by increasing levels of financialmarket integration.

Causal linkages between US and Eurodollar interest rates: further evidence

“…Mougoue and Wagster (1997) found bidirectional causality between the US and Eurodollar interest rates during 1973-1979, unidirec-tional causality from the Eurodollar rate to the US domestic rate during [1979][1980][1981][1982], and reverse unidirectional causality from the US domestic rate to the Eurodollar rate during 1982-1992. Similarly, Clinebell et al (2000 found unidirectional causality running from the US interest rate to the offshore LIBOR rate under the regime of borrowed reserves targeting.…”

“…Similarly, Clinebell et al (2000 found unidirectional causality running from the US interest rate to the offshore LIBOR rate under the regime of borrowed reserves targeting. Furthermore, both Mougoue and Wagster (1997) and Clinebell et al (2000) argued that the evidence of unidirectional causality running from the US interest rate to the offshore rate did not support the argument of increasing financial market integration over time.…”

“…Mougoue and Wagster, 1997;Clinebell et al, 2000) argued that US Federal *Corresponding author. E-mail: jiyang@pvamu.edu 1 A similar controversy exists in some studies involving nonUS markets.…”

“…Recognizing nonstationarity of interest rates, more recent studies (Fung and Isberg, 1992;Mougoue and Wagster, 1997) exploited the notion of cointegration and the closely related error correction models (ECM) to conduct causality analysis. Such a consideration is important, as existence of cointegration and the significance of error correction term(s) is important to sound causal inference (Granger, 1988).…”

Macroeconomic news and the returns of financial companies

“…It is expected that financial services firms, particularly mutual fund companies and brokers, would be adversely affected by an unexpected monetary tightening that made investing in stock funds less attractive. In terms of financial institutions, Mougoue and Wagster (1997) found that bank deposit rates are significantly affected by monetary policy. A monetary policy tightening can be expected to raise the cost of borrowed reserves and decrease the supply of loans therefore placing upward pressure on lending rates.…”