The e¤ects of CBI’s policy rate on interest rates
in Iceland
A report to taskforce on reviewing Iceland’s monetaryand currency policies
Marías Halldór Gestsson
May 2018

1Introduction

A central bank uses its policy rate to a¤ect interest rates and, hence, asset prices,
exchange rates and aggregate demand in an economy. In this paper, we analyse
the transmission of the Central Bank of Iceland’s (CBI) policy rate throughthe …nancial system in Iceland, i.e. we analyse the e¤ects of the policy rate
on interest rates in Iceland. We use a structural vector autoregressive (SVAR)
model of the Icelandic …nancial system and use it to identify shocks to the policy
rate and analyse the e¤ects of changes in it on other interest rates in Iceland.
Pétursson (2001) analyses the …nancial system transmission of the CBI’s
policy rate using a SVAR model of the Icelandic …nancial system using monthly
data for 1993-2000. During this period, monetary policy in Iceland can becharacterized by exchange rate targeting under capital controls. He …nds thatchanges in the policy rate have statistically signi…cant e¤ects on the money
market rate for up to three months while the e¤ects on the indexed bond andloan market rates are statistically signi…cant for up to eight and nine months.1We apply the same methodology as in Pétursson (2001) and use monthly datafor 2011-2018 (January 2011 - February 2018). During this period, monetary
policy in Iceland can be described as in‡ation targeting under capital controls.
We analyse separately the transmission of monetary policy into the bank loan
market and the bonds market in Iceland.
The paper is organized as follows: The data is discussed in chapter 2 andthe econometric model is discussed in chapter 3. Estimation of the model isdiscussed in chapter 4 and the results of simulations are given in chapter 5,
which concludes the paper.
1 The transmission of monetary policy is also a part of the CBI’s QMM model (see QMM),
which is a general equilibrium macroeconomic model of the Icelandic economy used in forecasting by the CBI. The point estimates in the model show that an increase in the policy rate
results in the short nominal and long indexed interest rates increasing for approximately 20months (5 quarters). There are, however, no con…dence intervals given in their analysis and,hence, it is impossible to say whether the e¤ects are statistically signi…cant or not.

1

2DataWe use data on CBI’s policy rate (it ), three month REIBOR rates (mt ), rates
on bank loans (bnt ), rates on indexed bank loans (brt ), yield on government
bonds (RIKB250612) (snt ) and yield on indexed house …nancing bonds (srt )(HFF150644).2 All data was obtained from the the CBI’s Economic Indicators
published on March 28th 2018 (see Economic Indicators).3
The data series are shown in the following …gures:
Figure 1. The data series

2 The lending rates on bank loans are average lending rates of commercial banks. The
government bond expires in 2025 and the house …nancing bond in 2044.
3 The data published in Economic Indicators are weekly. Monthly data were obtained becalculating monthly averages.

2

3

3

Model

We analyse the transmission of the policy rate into nominal (nt ) and real (rt )rates in (i) the bank lending market (b) and (ii) the bonds market (s). Hence,we estimate two models - one for each market.
0The vector of interest rates is yt = (it ; mt ; nt ; rt ) and the Vector autoregressive (VAR) model can be written as (omitting constants, trend and dummy
variables):A (L) yt = ut
(1)0

where ut = (ui;t ; um;t ; un;t ; ur;t ) is a vector of one period ahead forecast errors(innovations to the VAR model), each of which is independently and identically
distributed with zero mean: uj;tiid (0; jj ) for j = i; m; n; r, E (ut ) = 0 (a(4 1) vector of zeros), E (ut u0t ) = where:
01B=B@ii

imin

immm

mnir

in

mnnnir

mrnr

CCAnr

mrrr

and A (L) is a vector of polynomials in L, L is a lag operator such that Ls yt =yt s and A0 = I (A (L) for s = 0). Note that VAR innovations are interpreted
as unforeseen development in the interest rates.
Following Pétursson (2001), contemporaneous part of the unforeseen development in the interest rates are assumed to follow the following processes:

or:ui;t=um;t=mi ui;t + "m;tun;t=ni ui;t +nm um;t + "n;tur;t=ri ui;t +rm um;t +mi01ni

nm

001rm

rn0
B
B
@"i;t1ri0rn un;t + "r;t100 CC u = "t0 A t
1(2)

where "t = ("i;t ; "m;t ; "n;t ; "r;t ) is a vector of structural shocks (behavioralshocks), each of which is independently and identically distributed with zeromean: "j;t iid (0; ! jj ) for j = i; m; n; r, E ("t ) = 0 (a (4 1) vector of zeros),E ("t "0t ) = where:01! ii
000B 0 ! mm00 CC=B@ 00! nn0 A000! rr

Note that while the structural shocks are independent of (orthogonal to) eachother this does in general not hold for the VAR innovations.
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Estimation

Since the (4 4) matrix in (2) is lower triangular, estimation of its parameters(the -as) as well as the variance of the structural shocks (the !-as) can beobtained from estimating the VAR model in (1) (estimating the parameters inA (L) and ), i.e. the structural model exactly identi…ed. Here, we are mainlyinterested in identifying the structural shocks to be able to analyse their impulseresponses.
We include …ve dummy variables when estimating the models below. Threeof those are to account for the e¤ects of various changes in rules set for implementing the capital controls in Iceland (March 2012, March 2015 and June2016). The other two are to account for the e¤ects of increased reserve requirements of commercial banks (October 2015) and the following decrease in thereserve requirements (December 2015). Further, we include a time trend in thebonds market model to account for the e¤ects of decreasing time until maturity
on the yield on the bonds used in the analysis.
For choosing the appropriate lag-length k we assume a maximum lag-lengthof six (k = 6) to have a fair number of degrees of freedom:

k
1
2
3
4
5
6
1
2
3
4
5
6

Table 1. Criterias for choosing the lag-length (k)
LogL4
AIC5
BIC6
HQC7 p-value8
Bank lending market model
1665:53
40:64
39:45
40:16
1682:3240:66
38:99
39:99
0:01
1689:21
40:43
38:29
39:57
0:62
1710:85
40:57
37:95
39:52
0:00
1730:68
40:66
37:57
39:42
0:00
1737:64
40:44
36:87
39:01
0:59
Bonds market model
1759:31
42:88
41:57
42:36
1780:79
43:02
41:23
42:30
0:00
1790:27
42:86
40:59
41:95
0:27
1796:99
42:62
39:89
41:53
0:64
1811:00
42:57
39:36
41:29
0:03
1816:96
42:32
38:63
40:84
0:75

The AIC criteria indicates that the appropriate lag-length is two or …ve in thebank lending market model and two in the bonds market model (the minimum
4 The value of the maximized log-likelihood function.
5 Akaike information criteria.
6 Bayesian information criteria.
7 Hannan-Quinn information criteria.
8 p-value for a test of lag-length. The null hypothesis is that the lag-length is kalternative is that the lag-length is at least k.

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1 and theof the AIC) while the BIC and HQC criterias indicate that a lag-length of one
is appropriate in both models (the minimum of the BIC and HQC). However,the p-value indicates a lag-lenght of …ve (k = 5) in both models, which is what
we assume below.
The results of misspeci…cation tests for (1) with k = 5 are given in thefollowing table:
Table 2. Misspeci…cation tests for (1) with k = 5Bank lending market Bonds market
Test
p-value
Autocorrelation9
0:77
0:19
Heteroscedasticity10
0:28
0:59
Normally distributed residuals11
0:00
0:07

The tests indicate no autocorrelation nor heteroscedasticity in the residualsof (1) for both models. The null hypothesis of normally distributed residuals isrejected for the bank lending model while the test is inconclusive for the bonds
market model.

5Results

The goal of this paper is to analyse how changes in the CBI’s policy ratesa¤ects other interest rates and yields in the Icelandic economy. This is done byanalysing how an unforeseen development in the policy rate (ui;t = "i;t ) a¤ects
these.
The following …gures show impulse responses from a one standard deviation
unforeseen increase in the policy rate in month 0 in the bank lending market
model ( i0 = ui;0 = "i;0 = 0:0009 = 0:09%):12
9 p-value for a test of autocorrelation of up to order 6 in the residuals (AR(6)). The null
hypothesis is that there is no autocorrelation of order 6 or lower in the residuals and thealternative is that there is autocorrelation of order 6 or lower.
1 0 p-value for a test of heteroscedasticity of up to order 6 (ARCH(6)) in the residuals. The
null hypothesis is that there is no heteroscedasticity of order 6 or lower in the residuals andthe alternative is that there is heteroscedasticity of order 6 or lower.
1 1 p-value for a Doornik-Hansen test of normally distributed residuals. The null hypothesisis that the residuals are normally distributed and the alternative is that they are not normallydistributed.
1 2 A one-standard deviation change is a typical change according to the model.
Note that since these are only unforeseen changes in the policy rate, the standard deviation
is much smaller than that of changes in the policy rate itself (0:09% vs. 0:6%)

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Figure 2. The e¤ects of an increase in CBI’s policy rate in the bank lending
market model

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The …gures above show the e¤ects of a 0:09% increase in the policy rate(it ) (monetary tightening) on itself, the money market rate (mt ), the bank loanrate (bnt ) and the indexed bank loan rate (brt ). The red lines give the point8

estimates of the e¤ects and the gray area gives the 95% con…dence interval forthe e¤ects. Note that since the policy rate is a stochastic variable in the model,
its path following an increase in it is a stochastic variable (hence the con…denceinterval).
The …rst three parts of …gure 2 show that an increase in the policy rate results
in a statistically signi…cant increase in the policy rate, the money market rateand the bank loan rate for approximately six months (the gray area is above thezero (horizontal) line for …ve months). The e¤ects on the policy rate itself re‡ectthat it tends to be signi…cantly higher for approximately six months following
an increase in it. The fourth part of the …gure shows that the e¤ects on theindexed bank loan rate are not statistically signi…cant.
The following …gures show impulse responses from a one standard deviation
unforeseen increase in the policy rate in month 0 in the bonds market model( i0 = ui;0 = "i;0 = 0:0009 = 0:09%):
Figure 3. The e¤ects of an increase in CBI’s policy rate in the bonds marketmodel910The …gures above show the e¤ects of a 0:09% increase in the policy rate (it )on itself, the money market rate (mt ), the bond yield (snt ) and the indexed bondyield (srt ). The e¤ects on the on the policy rate itself and the money market
rate are statistically signi…cant for appoximately …ve months (vs. 6 months inthe bank lending market model). The e¤ects on the bond yield and the indexedbond yield are statistically signi…cant in the same period as the increase in thepolicy rate occurs. Further, there are some indications of statistically signi…cante¤ects on the indexed bond yield approximately ten months after the increasein the policy rate.

References[1] Economic Indicators: https://www.cb.is/publications/publications/publication/2018/03/28/EconomicIndicators-28-March-2018/[2] Pétursson, Thórarinn G. (2001), The Transmission Mechanism of Monetary
Policy: Analysing the Financial Market Pass-Through, Central Bank of Iceland’s Working Paper No. 14.
[3] QMM: https://www.cb.is/publications/publications/publication/2015/12/01/WorkingPaper-no.-71-QMM-A-Quarterly-Macroeconomic-Model-of-the-IcelandicEconomy/
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