Interest rate Pass-Through in the Major European Economies - The Role of Expectations

Much of the literature on interest rate pass through assumes banks set retail rates in relation to contemporary market rates. We argue that future rates also matter, and if forecasts of future rates are included, the empirical specifications of many previous studies are misspecified. Including forecasts requires careful choice of the data and models used to make forecasts: a large number of variables could influence future market rates, suggesting that factor forecasts method may be an appropriate method to consider. We evaluate forecasts before including them in a model of retail rate adjustment for five interest rates in five European countries and the euro area as a whole. We find a significant role for forecasts of future interest rates in determining short- and long-run pass through, and we show that models which do not include future rates do not provide accurate estimates.