Wednesday, August 8, 2012

New Zealand and Australia’s Short Term Interest Rate Volatility
I plot the daily New Zealand Official Cash Rate (OCR), which is the Reserve Bank policy rate, and the Overnight Interbak Cash Rate, which is the interest rate banks charge each others.  I also plot the difference between the two rates (OCR minus the Overnight Interbak Cash Rate).  These are averages of daily data by month from 1999 to 2012.

Figure 1
The two rates are equal until late 2005, when the OCR jumped significantly such that the difference jumped from zero to 0.42, followed by a significant decline in both the OCR and the market rate.  In 2006, both rates diverged significantly and the differences never recovered; the divergence is significant and prolonged.

The Reserve Bank of New Zealand changed its operating procedure in 2006. The description of this policy change is found in a Bulletin article.[i]  Essentially, the Reserve Bank increased market liquidity significantly.  It made more money available for banks.  When the supply of money increases, the Overnight Interbak Cash Rate should fall, but that clearly did not happen immediately because the difference in figure 1 is negative until February 20007, indicating a rise in the market rate above the cash rate.  These differences suggests that the market was uncertain about the policy change, and perhaps the fact that the New Zealand financial market is very thin.

In 2008, the market rate began to equal or be less than OCR, reflecting the expected response to the policy.  Differences are positive in 2010 indicating the falling of market interest rate below the OCR and reflecting the policy change in 2006.  It took a very long time for market interest rate to fall.  However, the data were also reflecting the international financial crisis.

Let us look at the same data for Australia.  Australia maintained the same operating procedure throughout.  In this case we expect to observe the OCR and the Overnigh
Interbak Cash Rate to be equal all the time unless there are some shocks pushing the two rates apart.  Figure 2 shows that differences between the policy rate and the market rate occurred in early 1999.  From 2002 to-date, and during the international financial crisis, Australia’s OCR and the Overnight Interbak Cash Rate are almost identical, with differences equal to zero. The Australian market has been adequately liquid.

Figure 2

Figure 3 shows New Zealand’s OCR and Overnight Interbank Cash Rate’s volatility (uncertainty).

Figure 3
New Zealand’s monetary policy volatility, measured by the monthly average squared changes in the OCR during the financial crisis, has been low except for a short period in 2009.  Monetary policy and market volatility were equal and only began to diverge in the days and months leading up to the crisis, during and after the crisis. The market’s volatility has been significantly higher than monetary policy’s and continues to be so.  These persistent differences in volatility and persistent volatility in the financial market are important research questions, which might have some real implications.
It gets more interesting when comparing the New Zealand figures to Austraia.  Figure 4 shows that New Zealand's volatility is significantly different in Australia.  For Australia, both monetary policy and market volatility were identical and small throughout the crisis, except for a very small spike in 2009.  During the international financial crisis Australia’s OCR had a small blip.

Figure 4

The next two graphs plot the New Zealand and Australia’s OCR and Overnight Interbank Cash Rate together.

Figure 5
Monetary policy volatility during the financial crisis is higher in New Zealand than Australia’s?

Figure 6

Similarly, financial market volatility in New Zealand, just before, during and after the financial crisis are significantly higher than Australia’s. 

The interest rate volatility might have some implications for the level exchange rate, which will be investigated in the next blog, see Benigno et al. (2011).[i] 

[i] Benigno, G., P. Benigno, and S. Nistico`, Risk, Monetary Policy and the Exchange Rate, 2011.

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