The term structure of interest rates has been extensively studied (see, for example, Shiller, 1990, and references therein; Gómez-Valle and Martínez-Rodríguez, 2008 and Jiang and Yan, 2009). The empirical literature on this topic typically investigates Treasury securities (bond yields), and the term structure is commonly interpreted from the investors’ perspective. For example, the term structure is often expressed by equating the long-term rate to the average of current and expected future short-term rates plus an extra yield. The extra yield (or a term premium) is interpreted as compensation for the interest rate risk that investors bear from holding long-term bonds instead of short-term bonds. In this paper, I investigate the term structure of interest rates on banks’ certificates of deposit (CDs), which, to my knowledge, has never been studied. In addition, I investigate (monetary policy) interest rate pass-through based on the theory of the term structure of CD rates developed in this paper. More specifically, the primary objective is to derive clearly interpretable components that constitute a term premium associated with CDs. These components are shown to be consistent with observed data, but they represent the perspective of the suppliers (banks) instead of the perspective of buyers (investors). The secondary objective is to estimate the pass-through from the monetary policy target, or the federal funds rate, to CD rates. Asymmetric characteristics of pass-through over business cycles are explained based on the paper’s theory and empirical evidence of the term structure of CD rates.
The secondary objective is related to Hofmann and Mizen (2004) and other recent studies (for example, Liu et al., 2008) in that short-term rates vis-à-vis monetary policy are investigated. Generally, short-term money market rates (including CD rates) are considered unimportant for the efficacy of monetary policy, and their pass-through is presumed to be rather trivial. What matters for monetary policy is the pass-through from the FF rate to long-term interest rates (Bernanke, 2004). The study by Hofmann and Mizen (2004), which is especially relevant to the present research for a reason explained below, carefully investigates the presumption of trivial/complete pass-through of the average of UK banks’ base rates (which moves closely with the official rate) to short-term retail bank rates (90-day deposit account rates). Additionally, standard variable-rate mortgages are also investigated. Using a non-linear error correction model (ECM), they uncover rich complexities or non-linear adjustments of these retail rates to the average base rate. Specifically, when deviations of retail rates from the average base rate are widening (or expected to widen), the loss resulting from not adjusting retail rates becomes greater than the “menu cost” (the cost of resetting retail rates), thereby forcing banks to adjust more quickly. Conversely, when deviations are narrowing, banks have less incentive to adjust, resulting in slower or no change in the adjustment speed. Some differences aside (i.e., the UK data of Hofmann and Mizen, 2004, versus the US data of this paper), considering Hofmann and Mizen’s (2004) findings in this paper yields additional insights into adjustment of CD rates to the federal funds rate (explained in Section 6).
The remainder of the paper is organized as follows. In Section 2, the data used in this paper are described, and stylized facts (three observations) about CD rates vis-à-vis the federal funds rate are advanced. In Section 3, I derive the optimal CD pricing conditions from an intertemporal bank model. In Section 4, model calibration illustrates the consistency of each determinant of the CD rates in isolation with stylized facts. The term structure of CD rates is also summarized. In Section 5, empirical support for the term structure of CD rates is presented. Section 6 provides the pass-through estimation results, which are interpreted based on the term structure of CD rates. Section 7 concludes.
In this paper, I investigate the term structure of CD rates and its relationship with monetary policy (the FF rate). First, the paper’s model and its calibration predict that the CD rates, and hence their term structure, are governed primarily by the FF rate and secondarily by banks’ income smoothing and other behaviors. The prediction is consistent with the estimation results, implying that the pure expectations hypothesis does not hold for the CD rates and that the term structure of CD rates differs significantly from the standard description of the term structure of interest rates. The latter implication holds because the longer-term CD rate is an average of the current and expected future shorter-term CD rates with time-varying weights. Second, the adjustment toward the long-run equilibrium between the FF and CD rates is asymmetrical over the business cycle. In particular, the downturn phase of business cycles (when the FF is falling) appears to be accompanied by more aggressive income smoothing by banks – compared with the upturn phase – due to their pessimistic expectations of future profits. It causes the lower CD rates to persist, resulting in the lower quantity supplied of CDs. The compositional shift in banks’ liabilities during the downturn phase away from CDs toward transaction deposits may pose a greater withdrawal risk for banks
