Overnight interest rate volatility and its transmission along the euro area money market yield curve

Stabilising very short-term interest rates is one of the goals that inspires the design of the operational framework of the monetary policy applied by most central banks. The reason is that high volatility can obstruct the signalling of monetary policy stance, hinder the liquidity management of financial institutions and have adverse macroeconomic effects if the volatility is transmitted to the longer-term rates relevant to agents’ spending decisions. To achieve the aim of stabilising very short-term interest rates, there are basically two alternative procedures: more or less continuous intervention in the markets and setting minimum reserve requirements that oblige credit institutions to maintain a certain average amount of reserves on deposit with the central bank over a certain period. These reserves act as a buffer that helps to neutralise the impact that unforeseen shocks to the system’s liquidity have on market interest rates. Thus when liquidity is scarce and its price tends to rise, the institutions have an incentive to reduce deposits temporarily below the required average level and lend funds on the inter-bank market, thereby moderating the upward pressure. Abundant liquidity triggers an equivalent mechanism in the opposite direction. Both these alternative procedures have their advantages and drawbacks. The main problem with continuous intervention is that it discourages activity in the money markets, while the weakness of minimum reserve requirements is that their stabilising property vanishes during the last few days of the reserve maintenance period. The Eurosystem has opted for the second procedure. Hence, in the last few days of each maintenance period there is usually an increase in overnight interest rate volatility in the interbank market. Nevertheless, this greater variability would only be of concern if it impaired the signalling of monetary policy stance and, in particular, if it were transmitted to longer terms. In any event, there are instruments available to stabilise very short-term rates on specific occasions. Against this background, the present article focuses on the variability of the euro area overnight interbank interest rate. The article is organised as follows. After this introduction, we briefly describe the operational framework of the Eurosystem monetary policy; the third section reviews the volatility of this rate; the fourth analyses to what extent it is transmitted to longer maturities; and the fifth sets out the main conclusions.