limited pass through from policy to retail interest rates empirical evidence and macro economic...

8/2/2019 Limited Pass Through From Policy to Retail Interest Rates Empirical Evidence and Macro Economic Implications

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Limited Pass-Through from Policy to Retail

Interest Rates: Empirical Evidence

and Macroeconomic Implications

1 Introduction

Monetary policy affects the economythrough various transmission chan-els, e.g. interest rates, exchange

rates, asset prices, etc. One of themost important channels of monetary

olicy is the interest rate channel.he monetary authority sets policy

rates; these affect short-term moneymarket rates, which in turn influencemedium to long-term market rates, bank retail rates, etc. Borio and Fritz

(1995, p. 3) argue that “bank lendingrates are a key, if not the best, indica-tor of the marginal cost of short-termexternal funding in an economy.”Households and firms take out bankoans in order to finance consump-tion and investment expenditures.

herefore, the price of bank loans isey in the determination of final de-

mand and consequently inflation inan economy. However, not only bank

ending rates but also bank depositrates are important, as they influencethe saving vs. consumption (and the

aving vs. investment) decisions of

econom c agents.In this paper we focus on the in-

terest rate channel of monetary pol-icy transmission, in particular on thelink between policy rates and bankretail rates. The purpose of this paperis twofold: First, we summarize em-pirical evidence on the extent of thepass-through to retail rates in theeuro area and the U.S.A. and second,we discuss potential implications for

monetary policy and macroeconomictability.

ast literature on the pass-through to retail interest rates (e.g.Cottarelli and Kourelis, 1994; Mojon,2000; Angeloni and Ehrmann, 2003;de Bondt et al., 2005) documents that bank interest rates are characterized by a lower variance than money mar-ket rates. Put differently, banks typi-cally do not fully adjust retail rates

when market rates change. Banks areno neutral conveyors of monetarypolicy. Consider, for example, that a

Refereed by:

Burkhard Raunig.

Refereed by:

Burkhard Raunig.

In this paper we survey empirical evidence on the limited pass-through from policy toretail interest rates and summarize some recent research on potential implications for monetary policy and macroeconomic fluctuations. Empirical evidence suggests that whilethe pass-through is incomplete in the euro area as well as in the U.S.A., it appears to behigher in the U.S.A. This is especially true for the long-run pass-through. Research in thisfield suggests that a limited pass-through alters the Taylor Principle. In the case of aperfect pass-through, the Taylor Principle requires that policy rates increase by more thanone-to-one with an increase in (expected) inflation. If the pass-through is incomplete,policy rates have to respond by even more to compensate for the smoothing of retail

rates. However, the monetary policies currently implemented in the euro area and theU.S.A. seem to satisfy the conditions for a unique and stable equilibrium and thus avoid sunspot shocks. Furthermore, findings in the literature also show that a limited pass-through has implications for the stabilizing role of monetary policy and therefore,fluctuations arising from fundamental shocks.

Claudia Kwapil,

Johann Scharler

Claudia Kwapil,

Johann Scharler

JEL classification: E32, E44, E52Keywords: interest rate pass-through, financial systems, stability.


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Limited Pass-Through from Policy to Retail Interest Rates:Empirical Evidence and Macroeconomic Implications

onetary olicy & the conomy /06 ◊ 27

central bank wants to counteract

overheating in an economy and in-creases its policy rates, which is re-flected in an increase in money mar-ket rates. The ultimate effect on theeconomy will, however, depend onthe reaction of those interest ratesthat are relevant for aggregate de-mand, e.g. bank retail rates. Thus, alimited pass-through to retail rateswill have macroeconomic implica-tions.

From a theoretical point of view,it is not fully understood why retailrates do not track money market ratesmore closely. There are different ex-planations: One potential explanationis that the limited pass-through may be interpreted as an implicit contract between the bank and its customers,which arises as a consequence of long-term relationships (Berger and Udell,1992; Allen and Gale, 2004). That is,

banks with close ties to their custom-ers offer relatively stable retail inter-est rates in order to insulate the cus-tomers from volatile market rates.Moreover, a limited interest rate pass-through may also be the consequenceof adjustment costs (e.g. Hannan andBerger, 1991; Hofmann and Mizen,2004), like labor costs, computingcosts and notification costs. Becauseof these costs, banks refrain from fre-

quent interest rate adjustments andchange rates only when the gain of the change is larger than the associ-ated costs. Furthermore, in a varyinginterest rate environment banks canalso change other components of aloan or deposit contract, such as col-lateral requirements, fees, etc. Allthe causes for rigid retail interestrates mentioned above are similar tothe explanations for sticky consumer

prices (e.g. Fabiani et al., 2006). An-other explanation for a limited pass-through to retail rates is related to

asymmetric information and moral

hazard. In particular, banks have anincentive not to raise interest rates bytoo much, because borrowers whoaccept a higher rate are likely to be of

oor quality. If borrowers take up aoan at a high rate, they are moreikely to choose riskier projects, de-

creasing the expected value of theamount paid back.

Despite its unambiguous implica-tions for the volatility of retail rates, a

imited pass-through may have am- biguous consequences for businesscycle volatility. On the one hand, the banking sector may contribute to

acroeconomic stability by insulat-ing the economy from adverse inter-est rate shocks. This issue appears to be particularly relevant for bank- based financial systems like the euroarea where retail rates play a moreimportant role than in market-based

ystems like that in the U.S.A. (Allenand Gale, 2000). Issing (2002) arguesthat since relationship lending is rela-tively widespread in the euro area, business cycles should be smoother.

n the other hand, a limited pass-through also means that monetary

olicy actions are to some extent ab-orbed or smoothed by the bankingector. Thus, a limited interest rateass-through might interfere with the

tabilizing role of monetary policy(Scharler, 2006) in the sense that pol-icy-induced changes in short-term

arket rates are not fully transmittedto the economy. Moreover, a limited

ass-through alters the so-called Tay-or Principle (described in 3.1), whichis an important requirement for mac-oeconomic stability (Kwapil and

Scharler, 2006).he remainder of the paper is

tructured as follows: Section 2 sum-arizes the empirical evidence on the

ass-through process from money




28 ◊ onetary olicy & the conomy 06

market rates to retail rates. Section 3

resents simulations to investigate theeffect of a limited pass-through onmacroeconomic volatility and the stability criteria of equilibria. Finally,Section 4 summarizes and concludesthe paper.

2 Empirical Evidence on theIncompleteness of theInterest Rate Pass-Through

he literature on the pass-through to

retail rates distinguishes between thecost of funds approach” and themonetary policy approach” (Sander

and Kleimeier, 2004). The cost of funds approach focuses on the “price-etting decision” of banks. The cost of

funds mainly reflects the opportunitycosts that arise for a bank that issuesoans and the financing costs for a

bank that takes in deposits. One im-ortant criterion in this respect is the

maturity of the rates; de Bondt (2005)argues that retail bank and market in-terest rates have to be of comparablematurity to avoid maturity mis-matches. Thus, mortgage loans, forexample, are better explained byong-term than by short-term inter-est rates. In contrast to that, the mon-etary policy approach is interested inthe effect monetary policy has on re-tail rates and includes no other ex-

lanatory variables. It focuses solelyon the question of how closely retailrates follow policy rates. Followingthe work of Cottarelli and Kourelis(1994), most of the empirical estima-tions found in the literature use anequation similar to

∆ ∆ ∆r c i r

r i

t j t j k k

m

t k j

n

t t

= + + +

−

−=

−=

− −

∑∑α β

γ

10

1(

11)

( )

here t is the retail rate of banks, i sthe interest rate targeted by the cen-tral bank and ∆ denotes the differ-

ence operator. As most studies find

that the retail rate, as well as thepolicy rate, are integrated of order 1,it is common to estimate the equationin first differences to avoid the prob-lem of spurious regressions. Thus, achange in retail interest rates is ex-plained by a change in monetary pol-icy rates, the persistence of a changein the retail rate and an error-correc-tion term, which allows for a long-term relationship between the retail

and the policy rate. The number of lags ≤ 6 and ≤ 6 are chosen accord-

ing to the Akaike Information Crite-rion.

When estimating this equation,one is interested in the immediatepass-through, which is given by α0. Itgives the reaction of retail rates to achange in policy rates within the sametime period. The second piece of in-formation worth looking at is the

long-run multiplier λ as defined inequation 2. It shows by how much theretail rate changes in reaction to achange in the policy rate by 100 basispoints after all adjustments have takenplace. This long-run multiplier is de-fined as:

λ α

β =

−,

=

=

∑

∑

j

n

j

k

m

k

0

11

(2)

where α j and β k are the coefficients onthe policy rate and the retail rate,respectively, and n and m give thenumber of lags chosen when estimat-ing equation 1. A high long-run pass-through might, thus, be due to highdirect effects passed through frompolicy rates to retail rates or a highpersistence in the retail rates. If λ isequal to 1, the pass-through is said to

be complete in the long run andchanges in policy rates are to the fullextent transmitted to retail rates.





s monetary policy rates andshort-term money market rates (e.g.

the three-month money market rate)move closely together, money marketrates are often taken as proxies forpolicy rates. Additionally, policy ratesare constant for long time periods andchange only when policy decisions aretaken, which makes them less suit-able for econometric purposes. Thatis why we use money market rates in-stead of policy rates in the followinganalysis.

hart 1 shows the three-monthmoney market rate (dotted line) asa proxy for policy rates and fourselected retail interest rates fromthe euro area. We chose two depositrates and two lending rates with dif-ferent maturities. Chart 1 shows quiteclearly that the pass-through differsdepending on the type of retail rate.While the interest rate on saving de-posits with a maturity of less than

three months is relatively constantand features a low pass-through, theinterest rate on time deposits with a

aturity of less than two years movesore in line with the money market

ate. A similar picture emerges frometail lending rates. While the inter-

est rate on loans to households doesot fluctuate much and, thus, has aow pass-through, the interest rateson short-term business loans movesquite in parallel with the money mar-et rate. This pattern of considerable

differences in the pass-through de-ending on the type of retail interestates found for the euro area is a com-

on finding in the literature. Mojon(2000), Sander and Kleimeier (2004),de Bondt (2005) and Kwapil andScharler (2006) share the result thatdeposit rates with short maturities(e.g. overnight deposits, saving de-

osits) have a lower pass-through thandeposit rates with longer maturities(e.g. time deposits). Furthermore,Sander and Kleimeier (2004), deBondt (2005) as well as Kwapil and

Scharler (2006) find that interestates on short-term loans to corpora-

tions (prime rate) feature a higher

Chart 1

Jan. 96 July 96 Jan. 97 July 97 Jan. 98 July 98 Jan. 99 July 99 Jan. 00 July 00 Jan. 01 July 01 Jan. 02 July 02 Jan. 03 July 03

10

9

8

7

6

5

4

3

2

1

%

ime deposits <2 year (left-hand scale) Business loans < 1 y ar (left-hand scale)

13

12

11

10

5

Saving deposits < three months (left-hand scale) hree-month money mar et rate ( left-hand scale)

Loans to households (r ght-hand scale)

The Pass-Through from Money Market Rates to Bank Retail Rates

in the Euro Area1

Source: BIS.

1 Chart 1 presents synthetic euro area aggregates from January 1996 to September 2003.





ass-through than medium to long-term lending rates.

able 1 summarizes the findingsof the literature on the immediateand the long-term pass-through forthe euro area, where most authorsisted in the table use an equationimilar to (1). In general the authorsse monthly data, implying that the

immediate pass-through reflects theresponse of retail rates to changes inmoney market rates within the samemonth. Exceptions are Mojon (2000),

ho reports the response after threemonths as well as Kaufmann andScharler (2006), who use quarterlydata; thus, the immediate pass-through gives the response within thefirst quarter.

problem in comparing results

in the literature is that the authorscover different time periods and usedifferent data sources. Furthermore,ome use euro area aggregates, while

others take the average of country re-ults of only a few euro area countries

and, thus, use only a proxy for theeuro area. In some cases table 1 in-cludes ranges instead of point esti-mates. Ranges are given if the authorsreport estimates of the pass-through

to various retail interest rates.

Table 1 shows that there are con-iderable differences in the estimates

of pass-throughs in the euro area.However, the differences are not big-ger across studies than across retailinterest rates within one study as in-dicated by the ranges given in table 1.

he first common finding is that theadjustment of retail rates to changes

in money market rates does needome time and does not occur instan-

taneously, as the immediate pass-through is smaller than the long-termpass-through. This seems to be truefor deposit rates as well as for lendingrates. The second common finding isthat the immediate pass-througheems to be below 0.55 in all cases.his means that only around half of

the change in money market rates is

immediately passed through to retailinterest rates. For the long-term pass-through the range of estimates is big-ger. However, the results seem touggest that with only few excep-

tions, the long-term pass-through inthe euro area is below 1 and, thus,not complete. This indicates that banks indeed insulate their customersfrom volatile money market rates byabsorbing part of the changes.

able 1

The Pass-Through from Money Market Rates to Retail Rates in the Euro Area

Deposit rates en ing rates

imme iate long-term imme iate long-term

Mojon ( ) . 7 x .5 x

Angeloni an E rmann ( ) . .74 . .74

an er an Kleimeier ( 4) ~ . . – . ~ . .4 – .47

e Bon t ( 5) . – . 5 . 5– . .1 – .54 . –1.5

e Bon t et al. ( 5) . . . 4– . .4 – .74

Kwapil an c arler ( ) .1 . . 4 .4

Kaufmann and Scharler (2006) x x .48 x

Kleimeier and Sander (2006) .10–0.45 .25–0.80 0.25–0.45 .65–0.75

orensen and Werner (2006) x .15–0.84 x .38–1.17

ote: Angeloni and Ehrmann (2003) estimate the immediate pass-through for the euro area using an average of deposit and lending rates.





able 2 summarizes pass-throughestimates for U.S. retail interestrates. Also for the U.S.A., one has tokeep in mind that the authors use dif-ferent data sets and cover differenttime periods. The estimates for thepass-through in the U.S.A. seem to behigher than in the euro area, and mostof the studies seem to suggest that thepass-through to U.S. retail rates is

nearly complete in the long-run.

3 MacroeconomicImplications

Since empirical evidence indicatesthat the pass-through to retail rates isincomplete, the question of what themacroeconomic implications of thisstylized fact are remains. On the onehand, one would expect that theeconomy is less exposed to interest

rate shocks. That is, shocks to theoverall liquidity situation on financialmarkets have a smaller impact onhouseholds and firms. This argumentapplies in particular to bank-basedeconomies like the euro area. Ange-loni and Ehrmann (2003, p. 10) ar-gue that banks are important for thetransmission of monetary policy in

the euro area, “given their over-helming role in financial interme-

diation in continental Europe.” Thus,it appears plausible that the euro areaeconomy experiences smoother busi-ess cycles than a more market-basedystem, as for instance the U.S.A.

However, a limited pass-through toetail rates also has the implication

that monetary policy is less effective

in the sense that policy-inducedchanges in short-term market ratesare not fully transmitted to the econ-omy.

In this section we focus on how aimited pass-through influences the

behavior of the economy in the faceof two different types of shocks. Thefirst type is the so-called “sunspothock,” which refers to self-fulfillingevisions in inflationary expectations.

Several authors argue that preciselythese shocks were a major source of

acroeconomic instability in the1970s (e.g. Clarida et al., 2000). Theecond type of shock is a fundamen-

tal shock. Scharler (2006) analyzesliquidity shocks, which are shocks tothe borrowing needs of firms, asexamples of fundamental shocks.

able 2

The Pass-Through from Money Market Rates to Retail Rates in the U.S.A.

Deposit rates en ing rates

imme iate long-term imme iate long-term

ottarelli an Kourelis (1 4) x x .41 . 7

Bor io an Fr itz (1 5) x x . 4 .7

Moazzami (1 ) x x . 4 1. 5

ellon ( ) x x x 1.

Angeloni an E rmann ( ) .74 1. .74 1.

Kwapil an c arler ( ) ~1. ~1. .7 .57

Kaufmann and Scharler (2006) x x 0.92 ~1.00

Note: Angeloni and Ehrmann (2003) estimate the immediate pass-through for the euro area using an average of deposit and lending rates.

1 Of course, differences in business cycle characteristics across countries may be due to various reasons, e.g. differentigidities, di erent types and magnitudes o shocks and their propagation mechanism. However, di erent inancial

ystems may be a potential explanation or these di erences in business cycle characteristics.





3.1 Limited Pass-Through and the

aylor PrincipleSeveral authors claim that the so-called Taylor Principle has importantimplications for macroeconomic fluc-tuations. Basically, the Taylor Princi-le holds that the nominal interest

rate has to respond more stronglythan one-for-one to changes in the in-flation rate to avoid self-fulfilling re-isions in expectations. Intuitively, if ominal rates do not adjust suffi-

ciently, a rise in expected inflationeads to a decrease in the real interestrate, which stimulates aggregate de-mand. Higher aggregate demand re-ults in an increase in inflation, and

consequently the initial expectationis confirmed. An economy subject tothis type of “sunspot shocks” will behighly unstable, and business cycles

ill be characterized by large fluctu-ations.

Consider a simple Taylor Rule as adescription of monetary policy:

i i yt t t y t

= + − + ,−

ρ ρ κ π κ π 1

1( )( )

here it denotes the nominal interestrate targeted by the central bank, ρ isthe degree of policy inertia and

�and

y determine the response of mone-tary policy to changes in inflation (� )and the output gap ( y ), respectively.

learly, the Taylor Principle is satis-fied if κ �>1. Otherwise, an increase ininflation would lead to an increase inthe nominal interest rate by less thanone and would thus induce a declinein the real interest rate.

However, as shown in Kwapil andScharler (2006), the standard TaylorPrinciple is not sufficient to rule out

fluctuations due to self-fulfilling ex-

pectations when the interest ratepass-through is limited. Put differ-ently, although monetary policy ap-pears to be tightened sufficiently, re-tail interest rates do not respond suf-ficiently to ensure that real rates aretabilizing. It is shown that in this case

a modified Taylor Principle applies:κ � λ>1, where λ denotes the long-termpass-through to retail rates. The in-tuition is straightforward: For low

values of λ, changes in the monetarypolicy rate are to a large extent ab-orbed by the banking sector and not

passed on to households and firms.Hence, if expected inflation in-creases, monetary policy has to betightened considerably to have a stabi-lizing effect on aggregate demand.For λ = 1 the pass-through to retailrates is complete at least in the longrun, and we obtain the standard

aylor Principle.Ultimately, our aim is to analyze

how the pass-through process to re-tail interest rates influences equilib-rium determinacy and macroeco-nomic stability. Empirical evidenceurveyed in the previous section sug-

gests that for the U.S.A., the long-run pass-through to retail rates ishigher than in the euro area. More-over, the banking sector and there-

fore retail rates play only a relativelyminor role for the determination of U.S. aggregate demand (e.g. Allenand Gale, 2000). Thus, we may con-clude that κ �, which ensures a deter-minate equilibrium, is likely to behigher in the euro area than in theU.S.A.

2 Strictly speaking, this modi ied Taylor Principle applies to the case κ y=0. However, or empirically plausiblevalues or y , di erences are negligible.





Do the monetary policy rules

estimated for the European CentralBank and the Federal Reserve Banksatisfy the modified Taylor Principle?For the U.S.A., Clarida et al. (2000)find a value of 2.15 for κ for theVolcker-Greenspan period. Basedon real-time-data, Orphanides (2004)reports lower values of around 1.8.For the euro area, Gerdesmeier andRoffia (2004) estimate several speci-fications. Based on their preferred

specification, they obtain estimatesranging from 1.9 to 2.2. A preciseevaluation is complicated, since retailrates are only one category of interestrates relevant for the determinationof aggregate demand. However, theestimated values for appear to fallwithin the determinate region for both economies. Nevertheless, theeuro area, with its more bank-basedsystem and its smaller pass-through

to retail rates, may be closer tothe indeterminate region than theU.S. .

3.2 Limited Pass-Through and the

ransmission of Liquidity Shocks

How does a limited pass-through in-fluence the response of the economyto fundamental shocks? Scharler(2006) addresses this question withina New Keynesian business cycle

model where fluctuations arise due toliquidity shocks. Firms have to bor-row working capital to finance pro-duction. In particular, a fraction of the wage bill has to be paid in advanceof production, and stochastic fluctua-tions in this fraction are interpretedas liquidity shocks. The paper focuseson these shocks, which may be inter-preted more generally as shocks tothe demand for credit, since the role

of the banking sector as a shock ab-sorber might be particularly relevantto such liquidity shocks.

In this model, a liquidity shock

aises the borrowing needs of firms,increasing their interest payments onthe working capital and making pro-duction more costly. This affects theupply and pricing decision of the

firm. Higher costs of the workingcapital are likely to lead to decreasesin the volume of production and up-

ard price adjustments. The increasein inf lation leads to a monetary policyesponse and thus to an increase in

the policy interest rate, which in turneads to an increase in lending ratesand raises costs even further by mak-ing working capital more expensive.

hus, the response of monetary pol-icy tends to amplify the shock. Inter-est rate smoothing by the bankingector dampens the increase in in-

flation and therefore leads to a small-er increase in policy rates. Conse-quently, a limited pass-through re-

duces the volatility of business cyclesin this setup. However, quantitatively,the reduction in volatility is found to be small. Thus, a financial system thatonly insulates the business sector of the economy against liquidity shocksincreases macroeconomic stabilityonly marginally.

However, liquidity shocks affectaggregate demand more generally.Since monetary policy is tightened in

esponse to the liquidity shock, it isot just corporate lending rates which

are increased, but retail rates in gen-eral. Hence, in addition to the initialiquidity shock, the economy faces an

aggregate demand shock, as house-holds delay consumption. Simulationshow that if the long-run pass-through

to retail rates in general is incom-lete, meaning that banks do more

than just smooth fluctuations in the

olicy rate, but partly absorb thesefluctuations even in the long run,then larger reductions in aggregate





olatility are obtained. However, the

ower volatility of output in this casecomes at the cost of a more volatileinflation rate. This result can be un-derstood in terms of how an imper-fect interest rate pass-through altersthe Taylor Principle and the stabilityroperties of the model. Although we

have seen that monetary policy rulesestimated for the euro area and theU.S.A. rule out sunspot shocks, lim-ited pass-through also influences how

the economy responds to fundamen-tal shocks. Intuitively, lowering theong-run interest rate pass-throughhile keeping the policy response to

inflationary pressure fixed impliesthat monetary policy becomes moreaccommodating. Hence, the inflationrate becomes more volatile. Put dif-ferently, a limited long-run pass-through alters the trade-off betweenoutput and inflation stabilization

faced by the central bank. If banksabsorb policy-induced variations ininterest rates even in the long run, asthe empirical findings suggest, mon-etary policy in some sense becomesmore accommodating toward infla-tionary pressures.

4 SummaryIn this paper, we survey empiricalevidence on the limited pass-through

from policy to retail interest rates. Inaddition, we summarize some recentresearch on potential implications for

monetary policy and macroeconomic

fluctuations which arise from a lim-ited pass-through.

Empirical evidence suggests thatwhile the pass-through is incompletein the euro area and in the U.S.A., itappears to be higher in the U.S.A.

his is especially true for the long-run pass-through.

What are the implications formacroeconomic fluctuations? Despitethe result that a limited pass-through

alters the Taylor Principle, we con-clude that currently implementedmonetary policy rules in the euroarea and the U.S.A. are likely tosatisfy the conditions for a deter-minate equilibrium. Put differently,even after taking limited pass-throughinto account, sunspot fluctuations areunlikely to arise. However, a limitedpass-through still has implicationsfor the stabilizing role of monetary

policy and therefore fluctuations aris-ing from fundamental shocks. Giventhe empirical evidence in favor of alimited long-run pass-through, anyreduction in output volatility that isdue to liquidity smoothing by the banking sectors is likely to be accom-panied by a more volatile inflationrate. Moreover, in addition to thecharacteristics of an interest rate rule,the long-run pass-through to retail

rates has to be taken into account forthe evaluation of monetary policy.





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