A comment on interest rate pass-through: a non-normal approach
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A comment on interest rate pass‑through: a non‑normal approach Dong‑Yop Oh1 · Hyejin Lee2 · Karl David Boulware3 Received: 18 January 2018 / Accepted: 8 April 2019 © Springer-Verlag GmbH Germany, part of Springer Nature 2019
Abstract This paper revisits the question of interest rate pass-through from the federal funds rate to bank and open market rates from the years 1987 to 2015. We employ cointegration tests with improved testing power by using information in non-normal errors. Using this approach, we find evidence of cointegration between the federal funds rate and the prime rate, the federal funds rate and the 3-month financial commercial paper rate, but no evidence of cointegration between the federal funds rate and the 30-year conventional mortgage rate. Moreover, we estimate the degree of long-run pass-through for both the prime and commercial paper rates to be less than one. Our results confirm that there is not only significant co-movement between the federal funds rate and short-term borrowing rates, but also that interest rate passthrough, in the long run, is incomplete. Keywords Monetary policy · Interest rate pass-through · Cointegration analysis · Non-normal errors · RALS JEL Classification E52 · E43 · E58 · C12 · C22
* Hyejin Lee [email protected] Dong‑Yop Oh [email protected] Karl David Boulware [email protected] 1
Department of Information Systems, Auburn University at Montgomery, Montgomery, AL 36117, USA
2
Accounting, Economics and Finance Department, Tuskegee University, Tuskegee, AL 36083, USA
3
Department of Economics, Wesleyan University, Middletown, CT 06459, USA
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1 Introduction Conventional monetary policy starts with the Fed setting the federal funds rate target. However, target changes apply only to overnight and interbank lending. What matters for real economic activity is the influence of the change in the federal funds target rate on the cost of credit to households and firms. Consequently, the transmission of monetary policy hinges on the degree of “pass-through” from the federal funds rate to other rates. If there is a complete transmission of monetary policy to aggregate spending in US economy, changes in the federal funds rate should transmit to bank loan and open market rates within a short period of time. In practice, however, relevant lending rates may not track the funds rate one for one. Possible explanations include: (1) a risk premium for credit risk; (2) market power, in which case the marginal cost of funds for a financial intermediary is less than the marginal revenue from making additional loans; and (3) banks’ loan supply, due, for example, to changes in capital adequacy. Moreover, longer-term interest rates, such as those on home mortgages, may also include term premiums and reflect expectations of future interest rates, both of which are likely to have been affected by the Fed’s post-2009 unconventional monetary policies—even with the funds rate constrained by zero lower bound policy.1 In this paper, we measure
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