MONETARY POLICY AND LONG TERM INTEREST RATES IN GERMANY * Ger Peersman Bank of England Ghen Universiy Absrac In his paper, we provide new empirical evidence on he relaionship beween shor and long run ineres raes for Germany. We find a posiive correlaion afer a supply and demand shock and a negaive correlaion afer a moneary policy shock. This finding is consisen wih he heory of Ellingsen and Södersröm (21). Key words: Moneary policy, erm srucure of ineres raes, SVARs. JEL-classificaion: E4-E5 * Inernaional Economic Analysis Division, Bank of England, Threadneedle Sree, London EC2R 8AH, e-mail: ger.peersman@bankofengland.co.uk. Telephone: +44 2 761 4182, Fax: +44 2 761 5288. The auhor is FWO pos-doc fellow a Ghen Universiy. This paper is wrien before I joined he Bank of England and he views expressed are solely mine and do no necessarily represen hose of he Bank of England. I hank an anonymous referee and Anders Vredin for useful suggesions.
1. INTRODUCTION There is sill a lo of uncerainy regarding he impac of moneary policy on longerm ineres raes. This is because he relaionship beween shor raes and long raes is believed o be based on he expecaions heory of ineres raes. In his heory, long-erm raes are an average of curren shor-erm raes and expeced fuure shor-erm raes. So, moneary policy affecs long-erm raes o he exen ha i influences curren and expeced shor-erm raes. This effec on long raes of a change in he sance of moneary policy will parly depend on he impac of he policy change on inflaion expecaions. The empirical evidence on he quaniaive effec of moneary policy on he longerm ineres raes finds on average a posiive relaionship: an increase in he cenral bank rae leads o an increase in ineres raes of all mauriies. 1 Romer and Romer (2) find his posiive movemen in he long rae inconsisen wih sandard moneary heory, because an increase in shor raes should reduce inflaion, and hence reduce he level of sufficienly long raes. Also, here are many excepions o his empirical phenomenon. Examples are declines of long-erm raes in response o a moneary ighening. Romer and Romer (2) explain his empirical finding by arguing ha when he Cenral Bank ighens moneary policy, marke paricipans infer ha i has unfavourable privae informaion abou he likely behaviour of inflaion, and hey herefore revise heir expecaions of inflaion upward. Ellingsen and Södersröm 1 For example: Cook and Hahn (1989), Dale (1993), Roley and Sellon (1995), Buiglione e al (1997), and Mehra (1996). 2
(21) consruc a model for he US wihin which he mechanism of Romer and Romer fis. The model hey use is aken from Svensson (1997), and is a dynamic version of a simple aggregae supply-aggregae demand model, where hey add an equaion for he erm srucure of ineres raes. They presume ha a change in moneary policy can have wo reasons: eiher he moneary auhoriies respond o new and possibly privae informaion abou he economy (such as supply and demand shocks), or heir policy preferences change (which is a moneary policy shock). In he firs case, moneary policy is endogenous, reflecing new inpu ino a given objecive funcion. In he second case, policy is exogenous because he inpu is he same bu he objecive funcion has changed. Afer an endogenous policy acion, heir model predics ha ineres raes of all mauriies move in he same direcion as he policy innovaion. On he oher hand, afer an exogenous policy acion, shor and long ineres raes should move in he opposie direcions. If he cenral bank becomes more averse of inflaion, he weigh of inflaion in he objecive funcion increases and here is a posiive exogenous moneary policy shock. This resuls in an unexpeced upward shif in he shor-erm ineres rae. However, because he preference of he moneary auhoriy has changed, economic agens have o adjus heir inflaion expecaions downward. The laer resuls in a decrease of sufficienly long-erm ineres raes. On he oher hand, if he economy is hi by a posiive demand shock, he cenral bank reacs o his shock by increasing he shor-erm ineres rae. However, also economic agens have o adjus heir inflaion expecaions upwards, resuling in a higher long-erm ineres 3
rae. 2 In he former case, here is a negaive correlaion beween he move in shor and long-erm ineres raes, in he laer case a posiive correlaion. In an accompanying paper, Ellingsen and Södersröm (1998) find posiive empirical evidence for heir proposiions by inerpreing newspaper repors from he Wall Sree Journal immediaely before and afer each meeing of he FOMC. In his paper, we provide new empirical evidence for Germany, confirming he heory of Ellingsen and Södersröm (21). To do so, we esimae a block-recursive SVAR for Germany, and invesigae he reacion of he erm srucure of ineres raes o supply, demand, moneary policy and exchange rae shocks. A similar mehodology is used by Evans and Marshall (1998) for he invesigaion of how exogenous impulses o moneary policy affec he yield curve in he US. The mehodology and he resuls are discussed in he nex secion. 2. METHODOLOGY AND RESULTS Le Y be a vecor of macroeconomic variables a ime. Le rae of mauriy j monhs. The following SVAR is esimaed: j R denoe an ineres Y R j A( L) = B( L) Y C( L) R 1 j 1 a + b ε 1 ε Y j (1) where a is a square marix wih ones on he diagonal, b is a row vecor, A(L) is a marix polynomial in he lag operaor L, B(L) is a row vecor polynomial, and C(L) is a scalar polynomial. Throughou our analysis, we mainain he assumpions ha neiher conemporaneous nor lagged values of he long-erm ineres raes ener he 2 The analysis of he consequences of a supply shock is similar. 4
oher equaions in he sysem. These assumpions ensure ha he shocks are invarian o bond mauriy j. For he basic block of endogenous variables and he idenificaion scheme for Germany, we follow Smes (1996). The advanage of his approach is ha he uses a mixure of shor and long-run idenificaion resricions (as in Gali, 1992). This is necessary o disenangle supply and demand shocks. The laer is no possible when we only use shor-erm resricions. The vecor of endogenous variables is: Y ' = [ y p s x ] (2) wih y denoing oupu growh, p he rae of inflaion, s he German overnigh ineres rae, and x he real effecive exchange rae. The vecor of srucural shocks is: Y s d p x [ ε ε ε ε ] ε = (3) Wih respecively a supply, demand, moneary policy, and an exchange rae shock. In order o idenify he supply shock, we assume ha here is no long-run impac of demand, moneary policy and exchange rae shocks on oupu. Furhermore, we assume ha here is no conemporaneous influence of moneary policy and exchange rae shocks on oupu. In order o disenangle he laer wo shocks, we follow he same sraegy as Smes (1996), Smes and Wouers (1999) and Mojon and Peersman (21), where here is a simulaneous impac of a moneary policy shock on he exchange rae and vice versa. We solve his simulaneiy problem by 5
esimaing he reacion coefficien on he exchange rae using he Japanese ineres rae and US dollar/yen exchange rae as insrumens. 3 Doing his analysis, we should be aware of he limiaions of our approach. Long run resricions are necessary o disenangle supply and demand shocks. The use of long-run resricions is, however, criicized by Faus and Leeper (1997). They find ha he esimaes could be biased in finie samples and if he rue number of shocks exceeds he number of idenified shocks in he VAR. 4 On he oher hand, Rudebusch (1998) criicizes he esimaed moneary policy shocks in a VAR. He finds ha he endogenous par of he ineres rae equaion does no always correspond o oher (more direc) evidence on he moneary policy reacion funcion and he correlaion of he shocks is small across various VARs and wih shocks ha are derived from forward-looking financial markes. To do he esimaion, we use monhly daa for he period 1979:1-1998:12. Figure 1 plos he response of respecively oupu, prices, he ineres rae and he exchange rae o supply, demand, moneary policy and exchange rae shocks, ogeher wih 1% confidence bands. The resuls are as expeced and similar o he ones obained by Smes (1996). As he exbook predics, a supply shock has a posiive influence on oupu and a negaive influence on prices. Afer a demand shock, oupu iniially increases o fall back o baseline afer a while. There is a permanen effec on prices. There is a emporary effec of a moneary policy shock on oupu, and prices decrease. The effec of an exchange rae shock is probably misspecified. 3 See Smes and Wouers (1999) or Smes (1996) for an explanaion of his wo-sep mehodology. 4 For an alernaive way of idenifying supply and demand shocks, see Peersman (22). 6
These shocks are associaed wih a large shock o he price level. This may be due o he fac ha exchange rae developmens are associaed wih moneary policy shocks (Smes, 1996). Figure 2 presens he responses of respecively he overnigh (from he basic VAR), he 1, 3, 6 and 12 monh ineres raes (swap raes), and he 3, 5, 7 and 1 year governmen bond yields o he supply, demand, moneary policy and exchange rae shocks. These resuls confirm he heory of Ellingsen and Södersröm (21). Afer supply and demand shocks, shor and long-erm ineres raes move in he same direcion. However, afer a moneary policy shock, shor and sufficienly long-erm ineres raes move in he opposie direcion. These resuls are very robus o oher specificaions. If we consruc a VAR like Bagliano and Favero (1998), or Mojon and Peersman (21), we also find a negaive correlaion beween he shor and long-run ineres raes. Wih he laer wo models and idenificaion sraegies, however, we canno make a disincion beween supply and demand shocks since hese models only use resricions on he conemporaneous impac marix. 3. CONCLUSIONS The impac of shor-erm ineres raes on long-erm raes is difficul o assess. This relaionship is believed o be based on he expecaions heory of ineres raes and parly depends on he impac of policy changes on inflaion expecaions. In his paper, we provided new empirical evidence on he relaionship beween shor and long-erm ineres raes using an SVAR for Germany. We find ha afer a supply and demand shock, shor and long erm ineres raes move in he same direcion. On he oher hand, afer a moneary policy shock, boh raes move in he opposie 7
direcion. This finding is consisen wih he heory of Ellingsen and Södersröm (21). REFERENCES Bagliano, F. and C. Favero, 1998, Measuring moneary policy wih VAR models : an evaluaion, European Economic Review, 42, 169-1112. Buiglione, L., Del Giovane, P. and O. Trisani, 1997, Moneary policy acions and he erm srucure of ineres raes : a cross counry analysis, Banca d Ialia Temi di discussione, No. 36. Cook, T. and T. Hahn, 1989, The effec of changes in he federal funds rae arge on marke ineres raes in he 197s, Journal of Moneary Economics, 331-351. Dale S., 1993, The effec of changes in official UK raes on marke ineres raes since 1987, The Mancheser School, vol LXI supplemen, 76-94. Ellingsen, T. and U. Södersröm, 1998, Classifying moneary policy, Sveriges Riksbank Working Paper, No. 56, par II. Ellingsen, T. and U. Södersröm, 21, Moneary policy and marke ineres raes, American Economic Review, 91(5), 1594-167. Evans, C. and Marshall, 1998, Moneary policy and he erm srucure of nominal ineres raes: Evidence and heory, Carnegie-Rocheser Conferences on Public Policy, 49, 53-112. Faus, J. and E. Leeper, 1997, When do long-run idenifying resricions give reliable resuls?, Journal of Business and Economic Saisics, 15(3), 345-353. 8
Gali, J., 1992, How well does he IS-LM model fi poswar US daa?, Quarerly Journal of Economics, 79-738. Mehra, Y., 1996, Some key empirical deerminans of shor-erm nominal ineres raes, Federal Reserve Bank of Richmond Economic Quarerly, 3, 33-52. Mojon, B. and G. Peersman, 21, A VAR descripion of he effecs of moneary policy in he individual counries of he euro area, ECB Working Paper, 92. Peersman G., 22, Wha caused he early millennium slowdown? Evidence based on vecor auoregressions, Bank of England Working Paper, forhcoming. Roley, V. and G. Sellon, 1995, Moneary policy acions and long-erm ineres raes, Federal Reserve Bank of Kansas Ciy Economic Review, 73-89. Romer, C. and D. Romer, 2, Federal Reserve informaion and he behaviour of ineres raes, American Economic Review, 9, 429-457. Rudebusch G., 1998, Do measures of moneary policy in a VAR make sense?, Inernaional Economic Review, 39(4), 97-931. Smes, F., 1996, Measuring moneary policy in he G7 counries : ineres raes versus exchange raes, mimeo. Smes, F. and R. Wouers, 1999, The exchange rae and he moneary ransmission mechanism in Germany, De Economis, 147(4), 489-521. Svensson, L., 1997, Inflaion forecas argeing : implemeaion and monioring inflaion arges, European Economic Review, 1111-1146. 9
Figure 1 Esimaed impulse response funcions for Germany (Esimaion period: 1979:1-1998:12) Oupu Prices Ineres rae Exchange rae 1.8.2.1 1 1.6 1.4.8 Supply shock 1.2 1.8.6.4.2 -.2 -.4 -.6 -.8 -.1 -.2 -.3 -.4 -.5.6.4.2 -.2 -.2 6 12 18 24 3 36 42-1 6 12 18 24 3 36 42 -.6 6 12 18 24 3 36 42 -.4 6 12 18 24 3 36 42 1.8.6.4 1 1.6 1.4 1.2.5.4.35.3.8.6 Demand shock 1.8.6.4.2.3.2.1.25.2.15.1.5.4.2 -.2 -.4 -.2 6 12 18 24 3 36 42 -.1 6 12 18 24 3 36 42 6 12 18 24 3 36 42 -.6 6 12 18 24 3 36 42.3.5.2 1.8 Moneary policy shock.2.1 -.1 -.2 -.3 -.5 -.1 -.15 -.2 -.25.15.1.5 -.5 1.6 1.4 1.2 1.8.6.4 -.4 -.3 -.1.2 -.5 6 12 18 24 3 36 42 -.35 6 12 18 24 3 36 42 -.15 6 12 18 24 3 36 42 6 12 18 24 3 36 42.4.6.15.3 Exchange rae shock.3.2.1 -.1.5.4.3.2.1.5.2.1 -.1 -.2 -.3 -.4 -.2.1 -.5 -.5 -.6 -.3 6 12 18 24 3 36 42 6 12 18 24 3 36 42 -.1 6 12 18 24 3 36 42 -.7 6 12 18 24 3 36 42 1
Figure 2 Esimaed impulse response funcions for Germany (Esimaion period: 1979:1-1998:12) Supply Demand Moneary policy Exchange rae.1.5.2.2.4 -.1.3.1.1 Overnigh -.2 -.3.2 -.4.1 -.1 -.5 -.6 -.1 -.2 -.1 6 12 18 24 3 36 42 6 12 18 24 3 36 42 6 12 18 24 3 36 42 6 12 18 24 3 36 42.1.5.2.2.4 -.1.3.1.1 1 monh -.2 -.3.2 -.4.1 -.1 -.5 -.6 -.1 -.2 -.1 6 12 18 24 3 36 42 6 12 18 24 3 36 42 6 12 18 24 3 36 42 6 12 18 24 3 36 42.1.5.2.2.4 -.1.3.1.1 3 monh -.2 -.3.2 -.4.1 -.1 -.5 -.6 -.1 -.2 -.1 6 12 18 24 3 36 42 6 12 18 24 3 36 42 6 12 18 24 3 36 42 6 12 18 24 3 36 42.1.5.2.2.4 -.1.3.1.1 6 monh -.2 -.3.2 -.4.1 -.1 -.5 -.6 -.1 -.2 -.1 6 12 18 24 3 36 42 6 12 18 24 3 36 42 6 12 18 24 3 36 42 6 12 18 24 3 36 42.1.5.2.2.4 -.1.3.1.1 1 year -.2 -.3.2 -.4.1 -.1 -.5 -.6 -.1 -.2 -.1 6 12 18 24 3 36 42 6 12 18 24 3 36 42 6 12 18 24 3 36 42 6 12 18 24 3 36 42.1.5.2.2.4 -.1.3.1.1 3 year -.2 -.3.2 -.4.1 -.1 -.5 -.6 -.1 -.2 -.1 6 12 18 24 3 36 42 6 12 18 24 3 36 42 6 12 18 24 3 36 42 6 12 18 24 3 36 42.1.5.2.2.4 -.1.3.1.1 5 year -.2 -.3.2 -.4.1 -.1 -.5 -.6 -.1 -.2 -.1 6 12 18 24 3 36 42 6 12 18 24 3 36 42 6 12 18 24 3 36 42 6 12 18 24 3 36 42.1.5.2.2.4 -.1.3.1.1 7 year -.2 -.3.2 -.4.1 -.1 -.5 -.6 -.1 -.2 -.1 6 12 18 24 3 36 42 6 12 18 24 3 36 42 6 12 18 24 3 36 42 6 12 18 24 3 36 42.1.5.2.2.4 1 year -.1 -.2 -.3.3.2.1.1 -.4.1 -.1 -.5 -.6 -.1 -.2 -.1 6 12 18 24 3 36 42 6 12 18 24 3 36 42 6 12 18 24 3 36 42 6 12 18 24 3 36 42 11