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Retail Interest Rate Pass-Through: The Irish Experience

Author

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  • Bredin, Don

    (Central Bank and Financial Services Authority of Ireland)

  • Fitzpatrick, Trevor

    (Central Bank and Financial Services Authority of Ireland)

  • O'Reilly, Gerard

    (Central Bank and Financial Services Authority of Ireland)

Abstract

Most central banks use a short-term interest rate such as the one-month money market interest rate as their main instrument of monetary policy. Changes to this short-term interest rate are the first important step in the transmission of monetary policy. Consumption and investment decisions made by households and firms will be affected by the rate of interest rate charged to them by banks and other financial intermediaries. A critical element of the transmission of monetary policy is the degree and speed at which changes in the short-term policy rate are transmitted to retail rates faced by firms and households. The term pass through refers to the extent to which changes in money market rates are reflected in changes in retail rates. This paper aims at increasing our understanding of this particular aspect of the monetary transmission mechanism in an Irish context between 1980 and 2001. In particular, we seek to answer two questions. 1) To what extent are changes in the one-month money-market rate passed through to various retail lending rates? 2) What is the speed at which changes in this money market rate transmitted to these lending rates? Understanding this process is important since it will determine in part how sensitive the domestic economy is to monetary policy changes as well as determining the speed at which the real economy responds to such policy rate changes. One of our main findings is that pass through from the money market rates to retail lending rates is not complete. In other words, lending rates respond less than one for one to changes in money market rates. For example, a one per cent change in the money market rate results in less than 0.8 of one per cent pass through to mortgage rates. Our results for the speed of adjustment are consistent with those of previous international studies. A significant part of our analysis is that we document the effect of a number of the more substantial developments in the financial environment over the sample period, namely, the institutional arrangements regarding the setting of retail rates, changes in competition and regulatory regimes in financial markets and changes in the conduct and operation of monetary policy. We find that such structural change has had a significant effect on the relationship between the money market rate and the various lending rates both in terms of pass through and speed of adjustment during this period. For example, we find that the dismantling of so called ‘matrix’ (an agreement on the setttng of various retail rates between the Central Bank and the Associated Banks) led to an increase in the degree of pass through between the money market rate and all lending rates considered. Failure to account for such change will lead to biased estimates of both the degree of and speed of pass through from money market rates to lending rates.

Suggested Citation

  • Bredin, Don & Fitzpatrick, Trevor & O'Reilly, Gerard, 2001. "Retail Interest Rate Pass-Through: The Irish Experience," Research Technical Papers 6/RT/01, Central Bank of Ireland.
    • Handle: RePEc:cbi:wpaper:6/rt/01
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