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Overnight money market rates are the predominant operational target of monetary policy. As a consequence, central banks have redesigned the implementation of monetary policy to keep the deviations of the overnight rate from the key policy rate small and short-lived. This paper uses fractional integration techniques to explore how the operational framework of four major central banks affects the persistence of overnight rates. Our results suggest that a well-communicated and transparent interest rate target of the central bank is a particularly important condition for a low degree of overnight rate persistence.

Overnight money market rates play a crucial role for signaling the intended interest rate level and the stance of monetary policy. In recent years, central banks redesigned their monetary policy instruments to ensure that the overnight rate closely follows the central bank’s key policy rate and that its volatility remains well contained. Mean and variance of the policy spreads, i.e. the deviation of the overnight rate from its policy-intended level, are often seen as indicators for the effectiveness of monetary policy implementation. This paper argues that controllability of the overnight rate additionally requires that the persistence of the policy spread remains sufficiently low. If the persistence of the policy spread is too high, the lasting impact of shocks would impede the signaling role of the overnight rate and the central bank’s control over interest rates. Recently, Cassola and Morana (2008) and Hassler and Nautz (2008) showed that the policy spread of the European Central Bank exhibits long memory implying that the central bank’s control of the overnight rate is weaker than expected. The current paper sheds more light on the role of the monetary policy design for the persistence of overnight rates. We explore how institutional differences in monetary policy implementation are reflected in the persistence of policy spreads. To that aim, we consider the policy spreads of the U.S. Federal Reserve, the European Central Bank, the Bank of England, and the Swiss National Bank where the reserve requirement system, standing facilities, open market operations and the implementation of the policy rate feature notable differences. Our paper adds to the growing literature on the role of monetary policy implementation for the behavior of interest rates. Following the seminal paper by Hamilton (1996), most contributions adopt the (E)GARCH framework to analyze cross-country differences in overnight rate volatility (Bartolini and Prati, 2006) or its transmission along the yield curve (Colarossi and Zaghini, 2009 and Nautz and Offermanns, 2008). Moreover, Pérez Quirós and Rodriguéz Mendizábal (2006) show that the introduction of the ECB’s symmetrical interest rate corridor has significant effects for overnight rate dynamics. Thornton (2006) and Nautz and Schmidt (2009) discuss the role of operating procedures for the Fed’s policy spread. In all these contributions on the dynamics and volatility of overnight rates, the policy spread is assumed to be integrated of order zero (I(0)) and the possibility of long memory is neglected. However, ignoring long memory may imply an underestimation of the persistence of shocks and adversely affect estimation results, see Sun (2006). Since the focus of our attention is on the persistence of overnight rates, we apply fractional integration techniques to allow for the presence of long memory in the policy spreads of central banks.1 Our results indicate that there are partially offsetting effects of a central bank’s monetary framework on the persistence of the policy spread. Nevertheless, the evidence obtained for different central banks and monetary policy implementation regimes suggests that a well-communicated and transparent interest target plays a particular role for keeping the persistence of the policy spread sufficiently low. The remainder of the paper is organized as follows. Section 2 briefly recalls the features of long memory models for measuring the persistence of time series. Section 3 discusses how the operational framework of a central bank could be related to the persistence of the policy spread. Section 4 introduces the data and presents the empirical results. Section 5 contains some concluding remarks.

This paper explored the relation between the persistence of the policy spread and the monetary policy implementation of a central bank. We characterized the monetary framework of the Bank of England (BoE), the U.S. Federal Reserve (Fed), the European Central Bank (ECB), and the Swiss National Bank (SNB) focusing on i) the role of reserve requirements, ii) the conduct of open market operations, iii) standing facilities, and iv) the implementation of the central bank’s policy rate. In cases of significant reforms of the monetary framework, we also considered the corresponding sub-samples to examine the impact of the institutional changes on policy spread persistence. We found that the central bank’s influence on the overnight rate depends on the monetary policy implementation regime. The use of fractional integration techniques revealed that policy spreads exhibit different degrees of persistence, indicating that the monetary policy design determines the strength of the relation between the overnight rate and the central bank’s policy rate. Our results suggest that the introduction of remunerated required reserves see e.g. O’Brien (2007) may reinforce the low persistence of the policy spread in the U.S. and, thereby, enhance the Fed’s control of money market interest rates. However, while the partial effect of a single monetary instrument is obvious in most cases, the combined effect of a whole set of instruments on policy spread persistence is less clear. Due to offsetting implications, for example, low persistence can be found in monetary regimes with and without effective reserve requirements depending on e.g. the frequency of open market operations and the transparency of the policy rate. The evidence found for the different monetary policy regimes indicates that the existence and clear communication of a target level for the overnight rate is a particular important condition for a low persistent policy spread. In particular, the increased role of the Federal Funds rate target and the Fed’s enhanced communication about the future interest rate path has significantly decreased the persistence of the policy spread in the United States. The merits of a well-communicated interest rate target for the controllability of the overnight rate can be seen in the behavior of the policy spread during the recent credit markets turmoil, see Taylor and Williams (2009). Although the volatility of the federal funds rate has sharply increased since August 2007, controllability of the federal funds rate has not been a major issue because the persistence of the deviations of the Federal Funds rate from its target has remained low.