The Effect of Monetary Policy on Private Money Market Rates in Jamaica: An Empirical Microstructure Study. Derek Leith

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1 The Effec of Moneary Policy on Privae Money Marke Raes in Jamaica: An Empirical Microsrucure Sudy Derek Leih Research Services Deparmen Research and Economic Programming Division Bank of Jamaica Absrac This paper provides a firs aemp a esimaing he effecs moneary policy has on ineres raes in he privae money marke using marke microsrucure variables. I also examines he impac of policy announcemens on hese raes. The naure of he relaionship beween moneary policy and/or policy announcemens on money marke ineres raes is invesigaed by examining he volailiy of ineres raes. Volailiy is esimaed by he GARCH model. The sudy uses daily daa from he privae money marke, Bank of Jamaica Open Marke Operaions and announcemens of ineres rae changes, for he period June 9, 005 o May 9, 009. The resuls show ha moneary policy has a mixed impac on he volailiy of ineres raes in he privae money marke. The overnigh segmen of he money marke is leas affeced by moneary policy changes. In addiion, here is volailiy spill-over from he hiry-day money marke o he inerbank segmen bu no o he overnigh segmen of he privae money marke. This lack of spill over o he overnigh marke suggess ha developmens o ha segmen of he marke may be limied. Keywords: Moneary Policy; Marke Microsrucure; Volailiy; Privae Money Marke. JEL Classificaion: E5, G19, G1, Mr. Leih is a summer inern in he Research Services Deparmen a he Bank of Jamaica. The views expressed are hose of he auhor and do no necessarily reflec hose of he Bank of Jamaica.

2 1.0 Inroducion Moneary policy has become he cenral ool of economic managemen in mos counries around he globe (Mishkin, 1995). I is herefore imporan ha he channels hrough which changes in moneary policy impac on he economy are well undersood. The money marke, which is he medium in which large insiuions and governmens manage heir shor-erm cash needs, has emerged as an imporan means by which moneary operaions are conduced by cenral banks. In hese markes, banks borrow and lend reserves, cenral bank money. These loans are shor erm loans, especially overnigh loans, and conribue o a beer allocaion of cenral bank money. The shor erm ineres rae in he economy is formed in hese markes and i influences he erm srucure of ineres raes. I is common knowledge ha mos cenral banks operae mainly a he shor end of he money marke and ransmi policy impulses o he longer end of he financial sysem hrough he erm srucure of ineres raes. Due o he increased role of argeing shor erm ineres raes in he ransmission mechanism, empirical research esablish ha he mos commonly pursued operaing arge in he conduc of moneary policy is he overnigh rae (see Ghosh and Bhaacharyya, 008). The reason being ha informaion abou he expecaions of fuure movemens in ineres raes is exraced from he prevailing marke raes. Cenral Banks implemen heir moneary policy by affecing ineres raes in he money marke, primarily hrough he yield in is ransacions wih credi insiuions. Their moneary policy obecives are realized by careful managemen of liquidiy condiions which faciliae money marke ransacions. While, cenral banks operae a he shor end, financial inermediaries operae over he enire lengh of he erm srucure. Therefore, o ensure orderly marke behavior from a financial sabiliy perspecive, i is imperaive for cenral banks o undersand wha goes on in he enire marke, especially in periods of excess volailiy. The developmen of he money marke (as well as credi, bond and foreign exchange markes) is imporan o he ransmission mechanism of moneary policy and improvemens in marke microsrucure. Due o he volailiy of shor-erm raes, paricularly hose in emerging marke economies, a deailed analysis of marke microsrucure is perinen (Ghosh and Bhaacharyya, 008). Marke microsrucure 1

3 explois he srucure provided by specific rading mechanisms o model how priceseing rules evolve in markes. This provides he abiliy o characerize how differen rading proocols affec price formaion, as well as o see why prices exhibi paricular ime-series properies. Marke microsrucure seeks o explain how laen supply and demand for financial asses are ransformed ino ransacions, and how his process drives asse-price dynamics. Microsrucure analysis invesigaes he insiuional srucure of financial markes, including informaion disribuion paerns and he resuling incenives faced by marke paricipans. This approach herefore can yield a deeper undersanding of how markes operae and how hey reac o and impound economic news and shocks. Furhermore, marke microsrucure research is able o exrac essenial informaion conained in hese markes in order o inform cenral banks on he hinking of marke players. This paper is similar in scope o Ghosh and Bhaacharyya (008), who sudy he ransmission effecs of moneary policy o he Indian money marke. However, i differs in ha i focuses no only on he overnigh money marke raes, bu he enire specrum of ineres raes. The mos recen research peraining o Jamaica is Jackson (008) and McLeod (008). In Jackson (008), he pass-hrough relaionship beween marke raes and bank reail raes across he Jamaican banking secor is examined, in order o ascerain he exen o which heir price seing behavior influences he pass-hrough. The Bank of Jamaica (BOJ) raes form he base on which he ineres rae srucure of he economy is buil and consequenly, adusmens effeced by he BOJ o is raes should have a powerful influence on privae money marke raes. McLeod (008) examines he ransmission of moneary policy o he privae money marke. The resuls reveal ha here is no direc correlaion and/or causaion operaing beween he BOJ ineres raes and he money marke raes, implying ha macroeconomic and microeconomic facors no examined, may have a sronger influence on hese raes. McLeod (008) recommends ha oher influences on privae money marke raes need o be empirically esed, for example, informaion such as banks or primary dealers whose behavior have a significan influence on money marke raes on a paricular day and oher microeconomic facors which could possibly influence marke raes.

4 The moivaion for his paper is wofold: firs, he sudy arises from he need o address he failings in McLeod (008) by employing microsrucure variables (volailiy, and rade volumes). 1 Second, he acions aken by policy-makers o adus ineres raes have been affeced by concerns relaing o he effec on he exchange rae and ineres raes in he money marke. These concerns relae large ineres rae movemens o increased volailiy in exchange raes and money marke raes. We conribue o he lieraure by examining he effec of BOJ ineres raes on he privae money marke ineres raes by focusing on he enire specrum of policy insrumens. A unique feaure of his sudy is ha we examine he impac of Governmen s presence in he marke, as well as any announcemens o adus policy raes. The res of he paper is organised as follows. Secion.0 reviews he relevan lieraure. Secion 3.0 develops he empirical model along wih he esimaion mehodology. This is followed by he descripion of he daa in secion 4.0. Secion 5.0 provides he empirical analysis, while secion 6.0 conains concluding remarks and policy implicaions..0 Lieraure Review Theoreical research ino he pricing of insrumens raded on he shor-erm money markes has been raher sparse and incomplee; however, here is considerable lieraure on he pricing of securiies in he equiy, bond and foreign exchange markes (Ho and Saunders, 1995). The reason for his pauciy of research, according o Ho and Saunders (1995), is he difficuly involved in modeling a marke which is so inimaely linked o banks (and oher deposiory insiuions ) reserve managemen decisions and herefore o moneary policy uncerainy. Addiionally, i is he cenraliy of his marke o he ransmission of moneary policy which makes modeling imporan, especially if he consequences of alernaive sraegies for conducing moneary policy are o be rigorously compared. Some heoreical work on he microsrucure of money markes by Bhaacharya and Gale (1987) and Bhaacharya and Fulghieri (1994) explain he exisence of privae 1 Daa availabiliy precludes an analysis using bid-ask spreads. 3

5 inerbank markes for shor-erm funds wih he need by banks o re-insure agains idiosyncraic liquidiy shocks coming from heir reail deposiors. More recen heoreical work addresses he issue of wheher his ype of liquidiy insurance causes sysemic risk in he banking sysem (see De Band and Harmann, 000, for a survey). Freixas and Holhausen (001) sudy he funcioning of he inernaional money markes, when informaion abou foreign banks is asymmeric. This heoreical money marke lieraure in general does no ackle he role of moneary policy, cenral bank operaions, and regulaions in he money marke. There, however, is research ha relaes he responses of he overnigh inerbank marke raes by a represenaive bank o moneary policy operaional procedures and money marke accouning convenions (see Ho and Saunders, 1985; Campbell, 1987; Spind and Hoffmeiser, 1988). Barolini e al., (1998) inroduce a role for cenral bank liquidiy provision and sudy he ineracion of profi-maximizing banks wih a cenral bank argeing ineres raes a high frequency. Research on he empirical aspecs of he microsrucure of money markes, despie being limied, focuses on modeling volailiy. In his seminal paper Hamilon (1996) shows ha he level and he volailiy of he Federal funds rae exhibi empirical regulariies ha may be associaed wih he moneary policy framework. Furher, wih respec o he US fed funds marke, Cassola and Morana (006a, 006b) esimae he underlying facors accouning for he volailiy of he euro overnigh ineres rae and is ransmission along he euro area money marke yield curve. The esimaes show repeiive inra-day, daily and monhly paerns ha can be explained by he microsrucure of he money marke. Furfine (1999) exploi he use of ransacion-level daa, which allow for a closer look a he microsrucure of he US fed funds marke. This is done by exploring he relaionship beween bank size and paricipaion, concenraion, inra-day iming and analyses of bank relaionship paerns. Invesigaions ino how well he markes are able o anicipae moneary policy acions of he Fed (Poole and Rasche, 000), indicae ha improved federal reserve ransparency and improved marke undersanding of policy have increased he accuracy of marke forecass of Fed policy decisions. According o Bernhbarden and Kloser (00), ransparency and predicabiliy can conribue o srenghening moneary policy credibiliy and enhance is effeciveness. They provide cross-counry comparison of some 4

6 OECD counries and find ha marke paricipans in advanced economies are beer able o anicipae moneary policy decisions, given he increased public availabiliy of informaion abou how moneary policy decisions are aken. A well funcioning money marke is essenial for conducing indirec, marke-based moneary policy operaions and for providing he necessary liquidiy for a marke in governmen and corporae bonds. Sudies on he microsrucure of he money marke in he euro area, for example, show ha i is heavily influenced by he insiuional environmen of he European Cenral Bank (ECB) and is moneary policy operaions (Harmann e al., 001). Research on he Euro-area money marke ypically finds ha he overnigh marke rae volailiy and spreads are relaively high on days wih ECB moneary policy announcemens, paricularly during mid-day when he ECB s ineres rae decisions are released. Relaed work done by Prai e al. (003), and Barolini e al. (00), link he behavior of very shor-erm ineres raes o he operaing procedures of cenral banks, suggesing ha shor-erm ineres raes are more srongly influenced by insiuional arrangemens raher han by exensively researched marke fricions. Barolini and Prai (003) show ha he volailiy of shor-erm ineres raes reflecs differences in cenral banks commimen o ineres rae smoohing. Ayuso e al. (1997) observe ha counries wih lower (higher) reserve requiremens end o have higher (lower) inerbank ineres rae volailiy and his effec shows up a all poins on he money marke yield curve- no us he shor end. Thus, here are some insiuional deails influencing money marke raes and heir volailiy. Ghosh and Bhaacharyya (008) esimae condiional volailiy in he Indian money marke. Using he GARCH model (Bollerslev, 1986), hey find ha he spread in he money marke is posiively relaed o condiional volailiy. The empirical resuls sugges ha expansionary moneary policy reduces volailiy of spreads and weighed call rae. In addiion, announcemens of Cash Reserve Raio (CRR) changes have a negaive impac on he volailiy of spreads and call rae, while oher policy variables like bank rae, repo and reverse repo raes have mixed impac on he volailiy of call rae and spreads. To deermine wheher very shor-erm volailiy is ransmied o he res of he yield curve, Durré and Nardelli (006) and Blanco and Alonso (005) uses differen 5

7 approaches o model volailiy. In paricular, Durré and Nardelli (006) consruc daily volailiy series using a sample of inraday observaions. The volailiy ransmission is sudied using a vecor auoregression across differen counries. Blanco and Alsonso (005) base heir raionale on a condiional volailiy model. The condiional volailiy of he overnigh rae is firs esimaed, and hen used as an explanaory variable in he represenaions of he condiional volailiy of longer-erm ineres raes. The findings of hese wo aricles sugges ha volailiy is no ransmied from very shor-erm o longerm ineres raes. More imporanly, he volailiy of he overnigh rae does no appear o influence ha of ineres raes beyond hree monhs. Sabiliy in financial and exchange rae markes is a vial obecive for Cenral Banks, paricularly he Bank of Jamaica, as large movemens in shor-erm ineres raes hisorically has significan implicaions for he sabiliy of hese markes. Large movemens in ineres raes end o cause volailiy in exchange rae markes as well as money markes asse prices, which increases he risks of holding domesic-currencydenominaed asses. Addiionally, hey also affec liquidiy available o financial insiuions and privae agens. In insances where shor-erm deb finances long-erm invesmen, a credi crunch may evolve. As a resul, policy-makers are always keen in asceraining as much informaion as possible regarding he impac of policy acions on financial markes, before adusing ineres raes. This is primarily due o uncerainy surrounding he effecs of hese decisions. Indeed, i is ypical for policy makers o delay aking acion unil ample informaion is acquired abou he possible effecs of a shock o financial markes or ha he acions aken are hose wih oucomes hey are confiden abou. 3.0 Mehodology To esimae volailiy in he privae money marke, we use he Generalised Auoregressive Condiional Heeroskedasiciy (GARCH) model (Bollerslev, 1986). This model is chosen based on is abiliy o capure volailiy paerns of high frequency financial ime series. The main assumpion behind his class of models ha makes i suiable for his sudy is he relaive homogeneiy of he price discovery process among 6

8 marke paricipans a he origin of he volailiy process. In oher words, he condiional densiy of he GARCH process is assumed o adequaely capure all he informaion and news in he marke. For his GARCH model, an auoregressive (AR) moving average (MA) - ARMA model, mus be assumed for he error variance. The GARCH (1, 1) model involves a mean equaion and he condiional variance equaion wih firs lag of squared residuals and he condiional variance. I is also a weighed average of pas squared residuals wih declining weighs which never assumes a zero value. The GARCH (1, 1) model is considered mos parsimonious of alernae variaions of he GARCH (p, q) model and will be employed in his framework. The GARCH (1, 1) model is specified as he following: Υ = φ φ1υ 1 ε (1) ε / ψ ~ Ν(0, h ) () 1 h = + β iε 1 + β h 1 α (3) In he above model, he dependen variable is he privae money marke rae while he BOJ OMO raes and he corresponding rading volumes will be modeled as he independen variables. The GARCH (1, 1) model (equaion 3) is augmened o include hese BOJ insrumens and he corresponding rading volumes. This is depiced in equaion (4). ϕ κ Capures he changes in volailiy while β reflecs he persisence in volailiy. h = + β iε 1 + β h 1 α + ϕ V k k (4) To capure he impac of policy announcemens on he volailiy of money marke ineres raes, he GARCH volailiy equaion (3) is augmened wih dummy variables. The augmened GARCH (1, 1) model is specified as follows: Y = + α1y 1 α 0 + ε (5) ε / ψ ~ Ν(0, h ) (6) 1 h * * * * * = + β i ε 1 + β h 1 α + τ D (7) * f f 7

9 where D is a dummy variable which akes he value 1 on he dae of announcemen of f moneary policy changes bu 0 oherwise. Dummy variables are creaed o explain he changes in he announcemens of various policy insrumens, including: he CRR, OMO rae. We also examine he impac of announcemens of GOJ issues, boh fixed and variable rae insrumens. For his exercise, we will pay close aenion o he changes in volailiy paerns of he money marke raes as i relaes o changes in policy announcemens. This is done in order o assess he impac policy announcemens may have on he underlying volailiy of he ineres raes in he privae money marke. A priori we expec ha volailiy persisence should be higher in he hiry-day segmen of he money marke because of he BOJ s perceived argeing of ineres raes a he longer end of he erm srucure, paricularly he 180-day ineres rae. Consequenly, i would be ineresing o see if his is so, and if i is, wheher here are volailiy spillover o he oher segmens of he money marke. This spill-over analysis is imporan o ascerain wheher or no moneary policy is ransmied o oher segmens of he marke, paricularly he 30-day segmen of he marke. To esimae he volailiy spill-over we augmen he condiional variance from he segmen of he marke ha has he lesser (or no) impac from moneary policy wih he condiional variance from he segmen of he marke ha has he greaes moneary policy impac. 4.0 Daa This paper uilises daily daa from he larges primary dealers in he privae money marke, which includes he overnigh, hiry-day and iner-bank ineres raes. 3 The daa cover he period June 9, 005 o May 9, 009 conaining 97 observaions. However, for comparaive purposes, we divide he daa ino wo sub-periods: sub-period one is from June 9, 005 o May 9, 007, while he second period is from May 30, 007 o May 9, 009. This is done in an aemp o capure he evoluion of volailiy in money marke ineres raes, which clearly shows he highly volaile naure of ineres Lile or no effec from moneary policy is signaled by an insignifican or smaller (compared o oher segmens) β. 3 See McLeod (008) for a deailed discussion on he privae money marke in Jamaica. 8

10 raes in he second sub-period as compared o he firs sub-period. Figure 1 show how volailiy evolves in he privae money marke. Figure 1. Volailiy of money marke ineres raes for wo sub-periods Firs sub-period Iner-bank marke Second period Iner-bank marke Condiional Variance Condiional Variance Apr-07 9-Feb-07 9-Dec-06 9-Oc-06 9-Aug-06 9-Jun-06 9-Apr-06 9-Feb-06 9-Dec-05 9-Oc-05 9-Aug-05 9-Jun Mar Jan Nov Sep Jul May Mar Jan Nov Sep Jul May-07 Dae Firs sub-period Iner-bank marke Dae Second period Iner-bank marke Firs period Overnigh marke Second period Overnigh marke Condiional Variance Condiional Variance Apr-07 9-Feb Dec-06 9-Oc-06 9-Aug-06 9-Jun-06 9-Ap r-06 9-Feb Dec-05 9-Oc-05 9-Au g-05 9-Jun Mar Ja n Nov Sep Ju l May Mar Jan Nov Sep Jul May-07 Dae Firs period Overnigh marke Dae Second period Overnigh marke Firs period Thiry-day marke Second period Thiry-day marke Condiional Variance Condiional Variance Apr-07 9-Feb-07 9-Dec-06 9-Oc-06 9-Aug-06 9-Jun-06 9-Apr-06 9-Feb-06 9-Dec-05 9-Oc-05 9-Aug-05 9-Jun Mar Jan Nov Sep Jul May Mar Jan Nov Sep Jul May-07 Dae Firs period Thiry-day marke Dae Second period Thiry-day marke The firs period of he daa (6/9/05-05/9/07) show GARCH (1,1) effecs of , and for he iner-bank, overnigh and hiry-day privae money 9

11 marke ineres raes respecively. These figures increased considerably during he second period, wih he β coefficiens reaching in he iner-bank marke, in he overnigh marke and in he hiry-day marke (able 1). Table: 1. Resuls of he GARCH (1, 1) model for Sub-periods. SEGMENT GARCH(1,1) Z-STATISTIC 1s Sub-period Iner-bank Overnigh Thiry-day nd Sub-period Iner-bank Overnigh Thiry-day These resuls coincide wih he second period being characerized by increased volailiy esimaes peraining o he financial crises emanaing from he U.S. and he underlying uncerainies exising in he domesic economy. The condiional variance from he GARCH equaion is graphed for each segmen of he privae money marke for he enire period highlighing he rend in he GARCH volailiy esimaes, see figure. Figure. Volailiy in he Privae Money Marke Iner-bank Marke Condiional Variance Dec Sep Jun Mar Dec Sep Jun Mar Dec Sep Jun Mar Dec Sep Jun Mar-07 Dae Iner-bank Marke 10

12 Overnigh Marke Condiional Variance Mar-07 9-Dec-06 9-Sep-06 9-Jun-06 9-Mar-06 9-Dec-05 9-Sep-05 9-Jun-05 9-Mar-09 9-Dec-08 9-Sep-08 9-Jun-08 9-Mar-08 9-Dec-07 9-Sep-07 9-Jun-07 Dae Overnigh Marke Thiry-day Marke 8 7 Condiional Variance Jun-06 9-Mar-06 9-Dec-05 9-Sep-05 9-Jun-05 9-Mar-07 9-Dec-06 9-Sep-06 9-Jun-08 9-Mar-08 9-Dec-07 9-Sep-07 9-Jun-07 9-Mar-09 9-Dec-08 9-Sep-08 Dae Thiry-day Marke The above graphs provide us wih informaion regarding he differences in he volailiy paerns beween he differen segmens of he privae money marke. Volailiy persisence is highes in he hiry-day segmen and he laer par of he graphs illusraes how volailiy paerns have increased over he years. The graphs also indicae volailiy clusering. We herefore examined he ineres raes in each segmen of he marke wih focus on he Kurosis and Skewness, we also es for GARCH effecs (heeroskedasiciy). This was done o deermine if he daa follow a normal disribuion and o verify ha he variance is ime-varying. The resuls (able ) show ha he daa is indeed non-normal. 11

13 Table : Summary Saisics of Ineres raes INTERBANK OVERNIGHT THIRTYDAY Mean Sd. Dev Skewness Kurosis Liquidiy managemen in he banking sysem is essenial for he smooh operaion of paymens and in paricular he real ime gross selemen (RTGS) sysem. The BOJ normally aims o saisfy he liquidiy needs of he banking sysem via is open marke operaions (OMOs). To deermine he impac of moneary policy insrumens on he money marke raes, we consider he full specrum of he Bank of Jamaica (BOJ) Open Marke Operaions (OMO) ineres raes. The 70-day and he 540-day OMO raes were excluded from his sudy due o insufficien daa spanning ha sample period. The mainenance of opimal liquidiy levels is crucial for cenral banks. Changes in he volume of money marke insrumens affec liquidiy and ineres raes. Cenral Bank deposis as well as purchase of reverse repurchases will affec he level of money and credi in he banking sysem in he shor-erm. Therefore, by looking a he volumes of cerificae of deposi (fixed and variable), he cenral bank deposis, and he oal volumes raded, we can idenify he impac hese volumes have on he volailiy of ineres raes in he money marke. The Cenral Bank can ake acions o influence he moneary base eiher hrough adusing ineres raes i offers on securiies or hrough adusing he volumes of OMOs ha i rades. Oher insiuional facors may be deerminans in deriving ineres raes in he money marke, for example, changes in policy announcemens (announcemens of rae changes). Thus, he announcemen daes of Cash Reserve Raio (CRR), OMO rae changes, and Governmen of Jamaica (GOJ) bond issue (fixed and variable) is used, in he form of dummy variables, o idenify any impac hese announcemens may have on he volailiy of ineres raes in he money marke. 1

14 5.0 Empirical Analysis 5.1 Iner-bank marke We firs look a he daily volailiy esimaed by he GARCH (1, 1) model for he inerbank money marke, for which he resuls are summarized in able 3. The β coefficien in equaion (3), which indicaes he persisency in he volailiy esimae, is repored in panel A. Generally, a high coefficien ( 0. 7 < β < 0.9) indicaes ha volailiy is very persisen. The repored β ' s in able 3 (beween 0.5 and 0.48) suggess fairly low persisency in volailiy of ineres raes in he iner-bank marke. The effec of OMOs on volailiy is presened in panel B and is represened by heϕ k. For he inerbank money marke rae, he cerificae of deposis (CD) fixed volumes and he oal volumes reduce volailiy, while he BOJ OMO raes and Cenral Bank (CB) deposis increase volailiy. The variable rae CD, however, is insignifican suggesing ha i does no have an impac on money marke raes. Volailiy persisence has increased wih he inroducion of he fixed rae CD s, bu has, however, decreased wih he CB deposis, volume oal and he BOJ OMO s. Regarding changes in policy announcemens, panel C, he BOJ OMO rae change provided he only increase in volailiy persisence in he inerbank rae, and has also increased is volailiy. The presence of he GOJ in he money marke (variable rae insrumen and issue dae) increases he volailiy of ineres raes in he inerbank marke. The announcemen of fixed rae GOJ insrumens and he CRR are insignifican implying ha hese announcemens have no impac on raes in he iner-bank segmen of he privae money marke. The 10 and 180-day BOJ OMO raes provided he sronges posiive influence on he persisence of volailiy of ineres raes in he inerbank money marke. 13

15 Table 3. Resuls of he GARCH (1, 1) model for he Inerbank Marke Panel A. INTER-BANK MARKET RESULTS* h = α + β iε 1 + β h 1 Panel B. VARIABLES β Z-STATISTIC α Z-STATISTIC GARCH(-1) INTEREST RATES AND TRADING VOLUMES h = α + β ε 1 + β h + ϕ V i 1 VARIABLES Z-STATISTIC ϕ Z-STATISTIC k CB DEPOSIT β CD s FIXED CD s VARIABLE VOLUME TOTAL DAY OMO DAY OMO DAY OMO DAY OMO DAY OMO DAY OMO Panel C. VARIABLES h ANNOUNCEMENTS * * + β ε 1 + β h + * * = α β k * f k τ D f Z-STATISTIC * τ Z-STATISTIC f CRR OMORATECHANGE GOJ ISSUE DATE GOJ FIXED GOJ VARIABLE Overnigh marke In erms of he overnigh money marke, announcemens of he GOJ (issue dae and variable insrumen) increases volailiy, while he CRR announcemen reduces volailiy in he overnigh segmen of he money marke (see able 4). Wih respec o he 14

16 oher variables, cenral bank deposis increase volailiy while he BOJ OMO, he CD s (fixed and variable) and he volume oal were all insignifican, having no impac on he volailiy of ineres raes in he overnigh money marke. Table 4. Resuls of he GARCH (1, 1) model for he Overnigh Marke Panel A OVERNIGHT MARKET RESULTS h = α + β iε 1 + β h 1 VARIABLES Panel B β Z-STATISTIC α Z-STATISTIC GARCH(-1) INTEREST RATES AND TRADING VOLUMES h = α + β ε 1 + β h + ϕ V i 1 VARIABLES Z-STATISTICS ϕ Z-STATISTICS k CB DEPOSIT β CD s FIXED CD s VARIABLE VOLUME TOTAL DAY OMO DAY OMO DAY OMO DAY OMO DAY OMO DAY OMO Panel C VARIABLES h ANNOUNCEMENTS * * + β ε 1 + β h + * * = α β k * f k τ D Z-STATISTIC * τ f f Z-STATISTIC CRR OMORATECHANGE GOJ ISSUE DATE GOJ FIXED GOJ VARIABLE

17 This resul is consisen wih McLeod (008) which finds ha he variaion in he overnigh money marke raes was no explained by BOJ ineres rae adusmens. Our resuls herefore suppor he argumen for idenifying deerminans of ineres raes in he overnigh marke. This is essenial for he developmen of his segmen of he money marke. The only variable ha is significan and increases volailiy of ineres raes in he overnigh marke is he CB deposis. 5.3 Thiry-day marke Wih respec o he hiry-day segmen of he privae money marke, Cenral bank deposis provided a posiive impeus o volailiy and volailiy persisence (able 5). This resul may be aribued o he reducion marke liquidiy when deposis increase. The fixed rae CD s and oal volumes reduce volailiy and volailiy persisence while he oher variables increase volailiy. The 180-day BOJ OMO rae has he sronges influence on 30-day privae money marke raes. 4 This resul is no surprising, since he 180-day OMO rae is generally he Cenral Bank s signal rae. Announcemens of CRR and OMO rae changes increases volailiy of ineres raes, panel C - Table 5. The GOJ variable rae insrumen is insignifican while he GOJ fixed rae insrumen decreases volailiy. The main channel hrough which he cenral bank manages liquidiy is hrough he domesic money marke, where shor-erm deb insrumens are used o smooh he level of money and credi in he sysem (indirec moneary ools). If here is no excess supply or demand for liquidiy and here are no shocks o he marke, hen volailiy paerns should be well behaved (no excess volailiy). We conduc a volailiy spill-over analysis o examine if volailiy in he 30-day marke is ransmied o he over-nigh segmen of he marke. This is relevan o idenifying he ransmission of moneary policy o differen segmens of he money marke. A direc impac of BOJ OMO insrumens in he over-nigh marke is no readily apparen, based on he insignifican coefficiens in able 4. To assess volailiy spill-over o he over-nigh segmen of he marke we augmen he GARCH equaion of he overnigh marke wih he condiional variances from he 30-day segmen of he marke. 4 This resul is similar o resuls in McLeod (008). 16

18 Table 5. Resuls of he GARCH (1, 1) model for he Thiry-day Marke Panel A THIRTY-DAY MARKET RESULTS h = α + β iε 1 + β h 1 VARIABLES Panel B β Z-STATISTIC α Z-STATISTIC GARCH(-1) INTEREST RATES AND TRADING VOLUMES h = + β iε 1 + β h 1 β α + ϕ V VARIABLES Z-STATISTIC ϕ Z-STATISTIC k CB DEPOSIT CD s FIXED CD s VARIABLE VOLUME TOTAL DAY OMO DAY OMO DAY OMO DAY OMO DAY OMO DAY OMO Panel C VARIABLES h ANNOUNCEMENTS * * + β ε 1 + β h + * * = α β k * f k τ D Z-STATISTIC * τ Z-STATISTIC f CRR OMORATECHANGE GOJ ISSUE DATE GOJ FIXED GOJ VARIABLE f The resuls indicae ha here is no volailiy spill-over from he 30-day segmen of he marke o he overnigh segmen of he money marke. However, here is a spill-over o he iner-bank marke. The implicaion of he resul of no volailiy spill-over is ha moneary policy acion ha affecs volailiy in he 30-day money marke has no effec on volailiy in he overnigh money marke. 17

19 Table 6 provides a summary of he resuls of he GARCH (1, 1) model augmened o include policy announcemens and variables ha increase he volailiy of ineres raes. The volailiy in he privae money marke has varying levels of persisence across he differen segmens, iner-bank, overnigh, and he hiry-day rae. The resuls reveal ha persisence in volailiy of he iner-bank rae is less han he overnigh and hiry-day money marke raes. This resul is consisen wih prior expecaions, since he raes offered in he iner-bank marke is he rae ha is used in rading beween banks, hus limiing he scope of compeiion for profi making. The GARCH effecs for he inerbank rae is compared o ha for he overnigh and he hiry-day money marke raes which are and respecively. Table 6. Summary of Variables and Announcemens Increase Volailiy VARIABLES INCREASING VOLATILITY MKT SEGMENT ANNOUNCEMENTS VARIABLES Iner-bank Overnigh Thiry-day OMO Rae change GOJ Issue dae GOJ Variable GOJ Issue dae GOJ Variable CRR OMO Rae change CB Deposis BOJ OMO s (full specrum) CB Deposis CB Deposis CD S Variable BOJ OMO s (full specrum) The salien implicaions arising from he resuls is ha volailiy in he money marke is affeced direcly by moneary policy ools, news announcemens of ineres rae changes and he presence of he GOJ in he marke. The hiry-day marke is more direcly affeced by moneary policy ools, while he overnigh marke is more direcly affeced by he GOJ s presence in he marke. While i is evidenly clear abou he effec of BOJ OMOs on he 30-day marke, he lack of effec of GOJs presence in he 30-day marke requires some explanaion. The underlying raionale here is ha since here is a penaly aached o breaking an invesmen prior o mauriy, he issuance of GOJ insrumens would see invesors readily using liquid funds available from he overnigh 18

20 marke raher han from he hiry-day marke o inves in hose insrumens. Hence he volailiy in ineres raes in he overnigh marke increases whenever GOJ is presen in he marke. 6.0 Conclusion and policy implicaions This paper provides he firs aemp o explore he ransmission of moneary policy o he privae money marke using microsrucure analysis. The sudy uilises he GARCH model as well as microsrucure variables in deermining he relaionship beween BOJ policy insrumens and he raes offered in he privae money marke. The resuls show ha generally volailiy is highes in he hiry-day segmen of he privae money marke and lowes in he iner-bank segmen. The BOJ open marke operaions have no impac on he overnigh money marke raes. However, OMOs increase volailiy in he iner-bank and hiry-day segmens of he money marke. There appears o be volailiy spill-overs from he hiry-day marke o he iner-bank bu none o he overnigh marke. Ineresingly, his spill-over is posiive for he iner-bank. In oher words, an increase in he volailiy in he hiry-day marke (possibly from moneary policy acion) causes an increase in he volailiy of ineres raes in he iner-bank money marke. Moneary policy and GOJ issue announcemens are also found o impac he raes offered in he money marke. In paricular, he OMO rae change, GOJ issue dae, GOJ variable insrumen and he CRR, all had mixed impacs on he volailiy of ineres raes in he respecive money marke segmens. This resul highlighs he need for a more comprehensive undersanding concerning he relaionship beween policy announcemens and money marke microsrucure, wih he aim of improving he efficiency and effeciveness of moneary policy iniiaives. The issue of he volailiy spill-over along he money marke yield curve shows ha here is no empirical evidence supporing he hypohesis ha volailiy of he hiryday ineres rae is ransmied o he volailiy of he overnigh ineres raes. This suggess ha moneary policy geared a liquidiy managemen via liquidiy shocks o he marke is no ransmied o he overnigh segmen of he money marke. One primary 19

21 implicaion here is ha a lack of volailiy spillover insulaes he yield curve from developmens in he overnigh money marke. In general, he funcioning of he money marke and is ineracion wih moneary policy receives lile aenion. The relaionship beween he policy raes deermined by he BOJ and money marke ineres raes is ypically close, sable and predicable. This is esimony o he design of he ools and procedures used o implemen moneary policy decisions, and o he effeciveness of he liquidiy policy conduced by he BOJ. However, wih he sabiliy of he relaionship in normal imes means ha he funcioning of he money marke and is ineracion wih moneary policy are awarded lile prominence in he analysis and discussion of moneary policy. The money marke plays a unique role in signaling he sance of he moneary policy and in ransmiing moneary policy decisions o financial markes. The ransmission mechanism occurs more generally o privae spending and saving decisions, and ulimaely o he deerminaion of he price level. 0

22 References Ayuso, J., Haldane, A.G. and Resoy, F., Volailiy Transmission along he Money Marke Yield Curve, Review of World Economics 133, Barolini, L., Berola, G. and Prai, A., Day-o-day Moneary Policy and he Volailiy of he Federal Funds Ineres Rae, EUI Working Paper ECO 98/35, European Universiy Insiue. Barolini, L., and Prai, A., 003b. Cross-Counry Differences in Moneary Policy Execuion and Money Marke Raes Volailiy, Federal Reserve Bank of New York Saff Repor No. 175, Ocober. Barolini, L., Berola, G., and Prai, A., 00. Day-To-Day Moneary Policy and he Volailiy of he Federal Funds Ineres Rae, Journal of Money, Credi and Banking 34 (1), Bernhardsen, T. and Kloser, A., 00. Transparency and Predicabiliy in Moneary Policy, Economic Bullein q, Norges Bank. Bhaacharyya, I., Roy, M., Josh, H., and Para, M.D., 009. Money Marke Microsrucure and Moneary Policy: The Indian Experience, Macroeconomics and Finance in Emerging Marke Economies (1), Bhaacharya, S. and Fulghieri, P., Uncerain Liquidiy and Inerbank Conracing, Economics Leers 44, Bhaacharya, S. and Gale, D., Preference Shocks, Liquidiy, and Cenral Bank Policy. In W.A. Barne and K.J. Singleon eds. New Approaches o Moneary Economics, Cambridge, U.K.: Cambridge Universiy Press, Blanco, R. and Alonso, F., 005. Is he Volailiy of he Eonia Transmied o Longer Term Euro Money Marke Ineres Raes? Banque d Espange, Working Paper No Campbell, J.Y., Money Announcemens, he Demand for Bank Reserves, and he Behavior of he Federal Funds Rae wihin he Saemen Week, Journal of Money, Credi, and Banking 19, Cassola, N., and Morana, C., 006a. Volailiy of Ineres Raes in he Euro Area: Evidence from High Frequency Daa, The European Journal of Finance. Cassola, N., and Morana, C., 006b. Comovemens in Volailiy in he Euro Money Marke, ECB Working Paper No

23 De Band, O., and Harmann, P., 000. Sysemic Risk: A Survey, ECB Working Paper 35. Durré, A., and Nardelli, S., (006), Volailiy in he Euro Marke: Effecs from he Moneary Policy Operaional Framework, Inernaional Journal of Finance and Economics 13, Ehrmann, M., and Frazscher, M., 004. Taking Sock: Moneary Policy Transmission o Equiy Markes, Journal of Money, Credi and Banking, 36(4), Freixas, X., and Holhausen, C., 001. Inerbank Marke Inegraion Under Asymmeric Informaion, Mimeo, Frankfur. Furfine, C.H., The microsrucure of he Federal Funds Marke, Financial Markes, Insiuions and Insrumens 8(5), Gaa, C., and Thurlow, P., Conference: Financial Marke Srucure and Dynamics, Bank of Canada, November 001. Ghosh, S., and Bhaacharyya, I., 009. Spread, Volailiy and Moneary Policy: Empirical Evidences from he Indian Overnigh Money Marke, Gurrola, P., and Herrerias, R., 009. Moneary Policy Announcemens and Ineres Raes Volailiy: Evidence from he Mexican TIIE Fuures Marke, Working Paper Series, February 9. Hamilon, J. D., The Daily Marke for Federal Funds Marke, Journal of Poliical Economy, 104(1), Harmann, P., Manna, M., and Manzanares, A., 001. The Microsrucure of he Euro Money Marke, Journal of Inernaional Money and Finance, 0, Ho, T.S.Y., and Saunders, A., A Micro Model of he Federal Funds Marke, Journal of Finance, 40 (3), Jackson, S.D., 008. The Dynamics of Bank Spreads in he Jamaican Banking Secor: An Empirical Assessmen. Financial Sabiliy Deparmen, Research and Economic Programming Division, Bank of Jamaica. McLeod, R., 008. The Lead-lag Srucure of Ineres Rae Relaionships in Jamaica, Moneary Analysis and Programming Deparmen, Research and Economic Programming Division, Bank of Jamaica, June. Mishkin, F.S., Symposium on he Moneary Transmission Mechanism, Journal of Economic Perspecives, Vol. 9, No. 4 (Auumn), pp.3-10.

24 Moore, R.W., and Williams, M.L., 008. Evidence on he Secoral Moneary Transmission Process under a Fixed Exchange Rae Regime, Deparmen of Economics, Universiy of The Wes Indies, Barbados and Jamaica. Poole, W., and Rasche, R.H., 000. Perfecing he Marke s Knowledge of Moneary Policy, Journal of Financial Services Research, Vol. 18, No. /3, pp Prai, A., Barolini, L., and Berola, G., 003. The Overnigh Inerbank Marke: Evidence From he G-7 and he Euro Zone, Journal of Banking and Finance, 7, Spind, P.A., and Hoffmeiser, J.R., The Micromechanics of he Federal Funds Marke: Implicaions for Day-of-he-week Effecs in Funds Rae Variabiliy, Journal of Financial and Quaniaive Analysis, 3(4), Srour, G., 001. Why Do Cenral Banks Smooh Ineres Raes? Bank of Canada Working Paper , Research Deparmen, Bank of Canada. 3

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