CFCM 10/03: How do anticipated changes to short-term market rates influence banks' retail interest rates? Evidence from the four major euro area economies

Abstract

Much of the literature on interest rate pass through assumes banks set retail rates by observing current market rates. We argue instead that banks anticipate the direction of short-term market rates when setting interest rates on loans and deposits. Including anticipated rates - captured by forecasts of short-term market rates or futures rates - in an empirical model requires a detailed consideration of the information contained in the yield curve. In this paper we use two methods to extract anticipated changes to short-term market rates - a level, slope, curvature model and a principal components model - at many horizons, before including them in a model of retail rate adjustment for four retail rates in four major euro area economies. Using both aggregate data and data from individual French banks, we find a significant role for forecasts of market rates in determining interest rate pass through; alternative specifications with futures information yield comparable results.

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Forthcoming in Journal of Money, Credit, and Banking and Banque de France working paper No. 361, February 2012

Authors

Anindya Banerjee, Victor Bystrov and Paul Mizen

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