TAILIEUCHUNG - Anticipation and Surprises in Central Bank Interest Rate Policy

Paying a market rate of interest on reserves could create cash flow problems for a central bank. One problem is that interest on reserves would be paid on a daily basis, but interest earnings would not accrue on a daily basis. Interest on short-term securities is paid on a discount basis rather than on a daily basis and interest on longer term securities is paid at infrequent intervals. Also, inevitably there will be periods in which the yield curve slopes downward, perhaps because the central bank had recently tightened policy and markets expect a return to lower overnight interest rates. | IMF Staff Papers Vol. 45 No. 4 December 1998 1998 International Monetary Fund Anticipation and Surprises in Central Bank Interest Rate Policy The Case of the Bundesbank DANIEL C. HARDY Market reaction to a change in official interest rates will depend on the extent to which the change is anticipated and on how it is interpreted as a signal of future policy. In this paper a technique is developed to separate the anticipated and unanticipated components of such changes and applied to estimate the response of euro-deutsche mark interest rates to adjustments in the Bundesbank s Lombard and discount rates. JEL E43 E47 Government officials financial market participants and agents in the economy at large attach importance to official central bank interest rates. What are termed official rates typically comprise the rates applied at one or more central bank standing facilities and in some cases at which the central bank operates a regular tender. In most industrialized countries as in a number of developing countries the central bank determines these rates both to define the range within which it manages short-term interbank rates through on-going open market operations and to signal its medium-term policy stance see Borio 1997 for a recent survey . A change in official rates can thus affect expectations that are reflected in longer-term interest rates and other financial market prices and hence initiate the monetary policy transmission process. It is therefore important that policymakers be able to predict the market response to such changes. Yet market participants have an incentive to anticipate policy shifts and insofar as they succeed market prices should largely adjust in advance of the implementation of a Daniel C. Hardy is a Senior Economist in the Middle Eastern Department. He thanks R. Flood H. Herrmann O. Issing J. Reckwert S. Schich . Todter J. Zettelmeyer and participants at a seminar at the Deutsche Bundesbank for their helpful comments. 647 648 DANIEL C.

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