THE IMPACT OF BSP POLICY INTEREST RATES ON MARKET INTEREST RATES1

Francisco G. Dakila, Jr. Racquel A. Claveria

Introduction
bservers have noted an apparent divergence between the BSPs policy interest rates, as represented by the overnight reverse repurchase or RRP rate, and market interest rates, as represented by the benchmark 91-day Treasury bill ( T-bill) rate (Graph 1). In theory, market participants take their cue from monetary authorities, so that increases in the BSPs policy interest rates would prompt a corresponding increase in market interest rates. In recent months, however, T-bill rates have remained low despite the increases in the BSPs policy interest rates. This article attempts to examine the extent to which BSP policy rates are able to influence market interest rates.

statistically significant links between the bellwether 91-day T-bill rate and a set of factors that we think may influence the former. In brief, econometric results tend to show that the BSP policy rate continues to play a significant role in the determination of the bellwether rate. Firstly, the RRP rate is the most significant determinant of 91-day T-bill rate as seen from the estimation output of the T-bill equation in the BSP Multi-Equation Model (BSP-MEM), shown in Table 1.2 The RRPO (-1) variable or the one-month lag of the RRP rate exhibits the highest statistical significance (beyond the 99% confidence level) compared to the other relevant factors behind the movement of the 91-day T-bill rate as follows: Deviation of nominal GDP from trend, lagged four months (LOG(GDPQ(-4))-LGDPSAHP(-4). The higher the deviation of nominal GDP from trend, the higher the 91-day T-bill rate.

Econometric Results
The best way to answer the question is through econometric analysis, which can be used to find

Graph 1

RRP Rates vs. 91-day T-bill Rates

January 2000 - March 2006

Bangko Sentral Review

January 2006

 Month-on-month changes in the exchange rate, lagged one month (D(LER(-1)). The higher the month-on-month change in the exchange rate, the higher the 91-day T-bill rate. 90-day LIBOR (LIBOR90). The higher the 90day LIBOR, the higher the 91-day T-bill rate.

Real money supply, lagged four months (LOG(M3(-4)/CPI2000(-4))). The higher the real money supply, the lower the 91-day T-bill rate. First-order autoregressive terms (AR(1)), which is meant to correct for seasonal variations.

Table 1 Dependent Variable: TBILL Method: Least Squares Sample (adjusted): 1988:09 1991:12 1992:02 1992:12 1993:02 1993:12 1994:02 2005:03 Included observations: 196 after adjustments Convergence achieved after 20 iterations Variable C LOG(GDPQ(-4)) LGDPSAHP(-4) D(LER(-1)) RRPO(-1) LIBOR90 LOG(M3(-4)/CPI2000(-4)) AR(1) AR(4) R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat Inverted AR Roots Coefficient 53.46856 1.562276 5.191072 0.104502 0.744998 -4.978056 0.980207 -0.071376 0.958931 0.957402 1.109110 231.2637 -294.3255 1.755605 .87 Std. Error 20.40123 1.451408 3.231428 0.014581 0.317862 2.155397 0.041048 0.040276 t-Statistic 2.620850 1.076386 1.606433 7.166774 2.343776 -2.309578 23.87948 -1.772180 Prob. 0.0095 0.2831 0.1099 0.0000 0.0201 0.0220 0.0000 0.0780 12.74857 5.373788 3.084954 3.218754 627.0980 0.000000 -.22+.32i

Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic) .55 -.22-.32i

Graph 2

Variance Decomposition of 91-day T-bill Rate

January 2006

Bangko Sentral Review

Estimation results show that these factors explain 96 percent of the changes in the 91-day T-bill rate. Secondly, in the very near term (2-3 months after a policy change), the RRP rate accounts for the largest source of changes in the 91-day T-bill rate next to the past trend of the 91-day T-bill rate itself (Graph 2). The percentage of variation in the 91-day T-bill rate due to changes in the RRP rate is highest at 24 percent during the third month and slowly declines to reach

13 percent in the tenth month. Subsequently, however, the exchange rate becomes the highest source of variation in 91-day T-bill rate (apart from changes in the 91-day T-bill rate itself), followed by the RRP rate. However, an impulse response analysis of RRP rates and the 91-day T-bill rate from a vector autoregression (VAR) model indicates that despite the RRP rate being the most significant determinant of

Graph 3

Response to Cholesky One S.D. Innovations +2 S.E.

Response of RRPO to RRPO Response of D(LER) to RRPO

Response of TBILL to RRPO

Response of LOG (M3/CPI2000F) to RRPO

Response of LOG (GDPQ)-LGDPSAHP to RRPO

Bangko Sentral Review

January 2006

the T-bill rate (apart from past changes in the T-bill rate itself), the pass-through from the policy rate to the T-bill rate may be limited.3 A VAR of RRP rate, month-on-month change in the exchange rate, 91-day T-bill rate, real money supply and deviation of GDP from trend shows that the bellwether rate responds to a change in the policy rate in the right direction (Graph 3). A one-time shock in the RRP rate by onepercentage point leads to a maximum increase in the 91-day T-bill rate by 0.7 percentage point in the second month and dissipates thereafter. Hence, while the RRP rate is second largest source of variation in the 91day T-bill rate in the near term, the impact of the former may be limited due to the minimal pass-through of the BSP policy rate to the bellwether rate. It may be worthy to note that using the effective RRP rate (ERRP) or the RRP rate adjusted for the

impact of the BSPs tiering scheme (for rates paid by the BSP on bank placements with the RRP window) does not materially alter the equation estimates and the interpretation of the econometric results (Appendix A).4

Shift to Inflation Targeting

An examination of the correlation for the period January 2000 to March 2006 between the RRP rate and the 91-day T-bill rate, both in the primary and secondary markets, remains fairly high at 0.84 and 0.85, respectively, using monthly data series (Table 3).5 However, this correlation weakened for the period January 2002-March 2006, following the adoption of inflation targeting. From the above, we note the following:

Table 3

Correlation Matrices
(January 2000 March 2006)

RRP rate

ERRP rate

91-day T-bill rate (primary) 0.843428 0.858916 1.000000 0.884862

91-day T-bill rate (secondary) 0.855609 0.876087 0.884862 1.000000

RRP rate ERRP rate 91-day T-bill rate (primary) 91-day T-bill rate (secondary)

1.000000 0.993167 0.843428 0.855609

0.993167 1.000000 0.858916 0.876087

(January 2000 December 2001)

RRP rate

ERRP rate

91-day T-bill rate (primary) 0.825056 0.813285 1.000000 0.593415

91-day T-bill rate (secondary) 0.782363 0.805753 0.593415 1.000000

RRP rate ERRP rate 91-day T-bill rate (primary) 91-day T-bill rate (secondary)

1.000000 0.990675 0.825056 0.782363

0.990675 1.000000 0.813285 0.805753

(January 2002 March 2006)

RRP rate

ERRP rate

91-day T-bill rate (primary) -0.455342 -0.002162 1.000000 0.911403

91-day T-bill rate (secondary) -0.395205 0.015696 0.911403 1.000000

RRP rate ERRP rate 91-day T-bill rate (primary) 91-day T-bill rate (secondary)

1.000000 0.778663 -0.455342 -0.395205

0.778663 1.000000 -0.002162 0.015696

January 2006

Bangko Sentral Review

1. The weakening is consistent with inflation targeting as a forward-looking framework of monetary policy. Under inflation targeting, the policy rate is set in consideration of how the inflation forecast compares with the target. By contrast, the correlation tables indicate that prior to inflation targeting, the policy rate may be more reactive to current financial developments compared to the current framework. 2. The focus towards the inflation outlook imparts a stabilizing trend to the policy rate. 3. For the period following inflation targeting, the correlation between the policy rate and the primary and secondary T-bill rates in fact turned negative.
Chart 1

adjusting the RRP rate for the impact of tiering restored the bi-directional causality between the bellwether rate and the policy rate. Using the ERRP rate, the results again show that prior to inflation targeting, causality ran from the secondary T-bill rate to the effective policy rate, but the direction of causality likewise reversed after inflation targeting. As in the previous case, the T-bill rate appears to have been determined largely independently of the effective policy rate for the inflation targeting period. In both cases, however, there is an indirect channel of feedback from the policy interest rate or the effective policy rate to the T-bill rate, through the secondary Tbill rate.
Chart 2

DIRECTION OF CAUSALITY Before IT

T-bill (secondary) T-bill (secondary) RRP

DIRECTION OF CAUSALITY Before IT

RRP T-bill (primary) T-bill (primary) RRP

After IT
T-bill (secondary) T-bill (secondary)

After IT
T-bill (primary) T-bill (primary) RRP

ERRP

ERRP

ERRP

ERRP

Granger causality tests support the hypothesis that a break in the way that policy rates have been set followed the introduction of inflation targeting (Appendix B). The direction of causality ran from the secondary T-bill rate to the policy rate prior to inflation targeting (Charts 1 and 2). After the adoption of inflation targeting, causality now runs in the opposite direction, from the policy rate to the T-bill rate. While there was significant bi-directional causality between the T-bill rate and the policy rate prior to the introduction of inflation targeting, the two rates appear to have been determined largely independently of each other for the inflation targeting period. Nonetheless,

Concluding Remarks
In summary, the BSP retains its capability to influence market interest rates through adjustment of the policy rate. Apart from the past trend in the T-bill rate itself, the policy rate is the most significant determinant of the T-bill rate over the very near term (within three months). Beyond this period, exchange rate changes begin to dominate the policy rate in influence on the T-bill rate. Nonetheless, the passthrough from the policy rate to the T-bill rate remains limited, in line with earlier simulations. Causality tests indicate that the channel of impact may also be indirect, through secondary market rates.

Bangko Sentral Review

January 2006

Dakila

Claveria

The Authors
Francisco G. Dakila, Jr. is the Officer-In-Charge of the Center for Monetary and Financial Policy (CMFP) and is concurrently Group Head of the Economic and Financial Forecasting Group (EFFG) of the Department of Economic Research (DER). Dr. Dakila holds a Doctor of Philosophy in Economics degree from the University of the Philippines. Racquel A. Claveria is Acting Bank Officer III at the EFFG of the DER. Ms. Claveria earned her Bachelor of Science and Master of Arts degrees in Economics from the University of the Philippines.

Endnotes
1

An earlier version of this article appeared in the BSP Inflation Report Third Quarter 2005. The authors are grateful to Mr. Dennis D. Lapid for his editorial comments. The BSP-MEM is a monthly model used by the BSP for inflation forecasting. It contains 12 equations, of which eight are behavioral equations, and the rest are identity equations. The key equation in the model is the inflation equation, which predicts month-on-month changes in inflation in terms of different factors, including the T-bill rate. A VAR expresses a variable as a function of its lag values and the lag values of other variables in the model. Meanwhile, an impulse response function traces the effect of a one-time shock to one of the innovations on current and future values of the endogenous variables. Under the tiering scheme, the interest rate paid on banks overnight RRP placements with the BSP decline successively as larger amounts of funds are placed with the BSP. This scheme implies a lower effective policy interest rate than the headline rate. The tiering system on bank placements with the BSP was removed effective 28 August 2003, whereby the overnight transactions under the RRP were accepted at a flat rate. The correlation coefficient measures the strength of association between two variables. The correlation coefficient ranges from 1 to +1. A value of +1 means that higher value of the first variable is always associated with higher value of the second. A value of 0 means no association, while a value of 1 means that higher value of the first variable is always associated with lower value of the second.

January 2006

Bangko Sentral Review