Monetary policy transmission mechanism and interest rate spreads

In contemporary times, monetary policy is evaluated by examining monetary policy shocks represented by changes in nominal interest rates rather than changes in the money supply. In this thesis, we studied three interrelated concepts: the monetary policy transmission mechanism, interest rate spreads and the spread adjusted monetary policy rule. Chapter 1 sets out a theoretical background by reviewing the evolution of monetary policy from money growth targeting to the standard approach of interest rate targeting (pegging) in the new consensus. The new consensus perspective models the economy with a system of three equations: the dynamic forward-looking IS-curve for aggregate demand, an inflation expectation-augmented Phillips curve and the interest rate rule. Monetary policy is defined as fixing the nominal interest rate in order to exert influences on macroeconomic outcomes such as output and expected inflation while allowing the money supply to be determined by interest rate and inflation expectations. Having set out this background, Chapter 2 empirically investigates long-standing questions: how does monetary policy (interest rate policy) affect the economy and how effective is it? This chapter seeks to answer these questions by modelling a monetary policy framework using macroeconomics data from Namibia. Using the new consensus macroeconomic view, this empirical analysis starts from the assumption that money is endogenous, and thus it identifies the bank rate (i.e. Namibia’s repo rate) as the policy instrument which starts the monetary transmission mechanism. We estimated a SVAR and derived structural impulse response functions and cumulative impulse response functions, which showed how output, inflation and bank credit responded to structural shocks, specifically the monetary policy and credit shocks in the short run and the long run. We found that in the short run quarterly real GDP, inflation and private credit declined significantly in response to monetary policy shocks in Namibia. Monetary policy shocks as captured by an unsystematic component of changes in the repo rate considerably caused a sharp decrease for more than three quarters ahead after the first impact in quarterly real GDP. Furthermore, structural impulse response functions showed that real GDP and inflation increased in response to one standard deviation in the private credit shock. In the long run, the cumulative impulse response functions showed that inflation declined and remained below the initial level while responses in other variables were statistically insignificant. South African monetary policy shock caused significant negative responses in private; however, the impacts on quarterly GDP were barely statistically significant in the short run. In all, this empirical evidence shows that the monetary policy of changing the level of repo rate is effective in stabilising GDP, inflation rate and private credit in the short run; and in the long run domestic monetary policy significantly stabilises inflation too. The structural forecast error variance decompositions show that the variations of output attributed to interest rate shock show that the interest rate channel is relatively strong compared with the credit channel. This is substantiated by the fact that repo rate shocks account for a large variation in output compared with the variation attributed to private credit shock. We conclude in this chapter that domestic monetary policy through the repo rate is effective, while the effects from the South African policy rate are not emphatically convincing in Namibia. Therefore, the Central Bank should keep independent monetary policy actions in order to achieve the goals of price stability. In Chapter 3 we investigate the subject of ‘interest rate spreads’, which are seen as the transmitting belts of monetary policy effects in the economy. While it is widely acknowledged that the monetary policy transmission mechanism is very important, it is also clear that the successes of monetary policy stabilisation are influenced by the size of spreads in the economy. Interest spreads are double-edged swords, as they amplify and also dampen monetary effects in the economy. Hence, we investigate the unit root process with structural breaks in interest rate spreads, and the macroeconomic and financial fundamentals that seem to explain large changes in spreads in Namibia. Firstly, descriptive statistics show that spreads always exist and gravitate around the mean above zero and that their paths are significantly amplified during crisis periods. Secondly, the Lanne, Saikkonen and Lutkepohl (2002) unit root test for processes with structural breaks shows that spreads have unit root with structural breaks. Most significant endogenous structural breaks identified coincide with the 1998 East Asia financial crisis period, while the global financial crisis only caused a significant structural break in quarterly GDP. Thirdly, using the definitions of the changes in base spread and retail spread, we find that inflation, unconditional inflation, economic growth rate and interest rate volatilities, and changes in the bank rate and risk premium and South Africa’s spread are some of the significant macroeconomic factors that explain changes in interest rate spread in Namibia. Whether we define interest spread as the retail spread, that is, the difference between average lending rate and average deposit rate, or the base spread, which is the difference between prime lending rate and the bank rate, our empirical results indicate that there macroeconomics and financial fundamentals play a statistically significant role in the determination of interest rate spreads. In the last chapter, we estimate the monetary policy rule augmented with spread - the so called Spread-adjusted Taylor Rule (STR). The simple Spread-adjusted Taylor rule is suggested in principle to be used as simple monetary policy strategy that responds to economic or financial shocks, e.g. rising spreads. In an environment of stable prices or weak demand, rising spreads have challenged current new consensus monetary policy strategy. As a result, the monetary policy framework that attaches weight to inflation and output to achieve price stability has been deemed unable to respond sufficiently to financial stress in the face of financial instability. In response to this challenge, the STR explicitly takes into account the spread to address the weakness of the standard monetary policy reaction in the face of financial instability. We apply the Bayesian method to estimate the posterior distributions of parameters in the simple STR. We use theory-based informed priors and empirical Bayesian priors to estimate the posterior means of the STR model. Our results from this empirical estimation show that monetary policy reaction function can be adjusted with credit spread to caution against tight credit conditions and therefore realise the goal of financial stability and price stability simultaneously. The estimated coefficients obtained from the spread-adjusted monetary policy are consistent with the calibrated parameters suggested by (McCulley & Toloui, 2008) and (Curdia & Woodford, 2009). We find that, on average, a higher credit spread is associated with the probability that the policy target will be adjusted downwards by 55 basis points in response to a marginal increase of one per cent in equilibrium spread. This posterior mean is likely to vary between -30 and -79 basis points with 95% credible intervals. Altogether in this chapter we found that a marginal increase in the rate of inflation above the target by one per cent is associated with probability that the repo rate target will be raised by an amount within the range of 42 to 75 basis points, while little can be said about central banks’ reaction to a marginal increase in output.