Monetary regime changes and the behavior of ex ante real interest rates: a multi-country study

Journal

of Monetary

Economics

26 (1990) 329-359.

North-Holland

Monetary regime changes and the behavior of ex ante real interest rates A multi-country

study*

Catherine Bonser-Neal Unrwrs~~ of Washmgton. Seattle.

WA 98195, USA

Received

received

July lY89, final verston

October

IYYO

Prevtous research has found that U.S. monetary regime changes are related to changes m the behavror of ex ante real interest rates. Thts paper erammes monetary regime changes in other countries to test whether changes m expected real interest rates are related to monetary regime changes m a systematic manner. The results show that while real rates have not been constant across monetary regtmss, the characteristics of the real rate process shifts differ across countries. Thts evtdence is consistent wtth theortes that predtct the neutrality of monetary regime changes wtth respect to real variables.

1. Introduction A well-known feature of rational expectations models is that policy regime changes can alter the stochastic behavior of economic variables. Several recent studies suggest that policy regime changes, in particular monetary pohcy regime changes, may also be empirically significant. For example, the creation of the Federal Reserve in 1914, the Treasury-Federal Reserve Accord of 1950, and changes in the Federal Reserve’s operating procedures in October 1979 and October 1982 have been associated with changes in the behavior of nominal interest rates, the term structure, and real interest *This paper is drawn from my doctoral dissertation at the University of Chicago. I would like to thank the members of my committee, John Huizinga. Michael Mussa. and John Cochrane for their Insightful comments and encouragement. I would also like to thank Rob Neal, Alan Hess, Rick Mishkin, Vance Roley, Simon Wheatley, and an anonymous referee for their comments on earlier drafts. Any errors are the sole responstbility of the author.

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330

C. Bonser-Neal,

Monetary regime changes and the behaL,ior of ex ante real Interest rates

rates.’ Empirical studies of the effects of monetary regime changes focus almost exclusively on these three U.S. policy shifts. Given the small sample of U.S. regime changes, however, these studies are limited in their ability to distinguish between changes in economic variables due to monetary regime shifts from those due to other economic shocks. Determining whether monetary regime changes systematically affect the behavior of economic variables requires a larger sample of regime changes and an examination of the robustness of the effects to the choice of time period and country. This paper provides additional evidence on the effects of monetary regime changes by comparing the effects of similar policy shifts that have been announced in four countries. Specifically, this paper tests whether monetary regime changes are systematically related to changes in expected real returns in Canada, Germany, the United Kingdom, and the United States. Evidence on the relation between monetary regime changes and the behavior of expected real returns is important for two reasons. First, whether monetary regime changes affect expected real returns can have important implications for the hypothesis that monetary regime changes are neutral with respect to real variables. If monetary policy regime changes affect the behavior of expected real returns, then the monetary authority may have some channel through which it can affect real economic activity.2 Second, existing evidence on the relation between monetary regime changes and the behavior of real rates yields mixed results. Huizinga and Mishkin (1986) find that the Federal Reserve’s October 1979 decision to adopt a nonborrowed reserves operating procedure and increase the emphasis on Ml targets was accompanied by a rise in the level and variability of expected real rates and with a decline in the strength of the Fisher effect. They also find the October 1982 decision to de-emphasize Ml targets was associated with a fall in real rate variability. Whether monetary regime changes caused these changes in the behavior of U.S. real rates has been challenged by Antoncic (1986), Schwert (19861, and Walsh (1988) who obtain different results using alternative specifications of real rate behavior. Since theory offers little guidance on the appropriate

‘Manktw and Miron (1986) and Mankiw, Moron, and Wet1 (1987) examine the effects of the creation of the Federal Reserve m 1914, Shiller (1980) exammes the Treasury-Federal Reserve Accord of 1951. Several studies have exammed the effects of changes in Federal Reserve ooeratina urocedures in 1979 and 1982. See, for example, Clarida and Friedman (1984), Mascaro and Meltzer (1983), and Melton and Roley (1990) on changes in the behavior of nominal interest rates. Blanchard (1984) and Hamilton (1988) on changes rn the term structure, and Hutzinga and Mishkin (1986) on changes in the behavior of expected real Interest rates. Chan (1988) also exammes the effects of the October 1979 and October 1982 changes in US. monetary policy. zAs shown by Turnbull (1981) and Benninga and Protopapadakis (1983), the expected real return on a nommally riskless asset has two components’ the expected risk-free real interest rate and a risk premium. While disentangling the separate effects of monetary regime changes on these two components IS beyond the scope of thus study, an Important first step is to examine the relation between expected real returns and monetary regimes.

C. Bonser-Neal, Monetary regtme changes and the behac,tor

of ex ante

real tnterest rates

331

empirical specification, evidence on the adoption of monetary targets in other countries may help resolve this issue. The null hypothesis of no relation between monetary regimes and the behavior of expected real interest rates is tested by comparing the behavior of short-term ex ante real returns surrounding two types of monetary regime changes announced by the four countries: the adoption of monetary targets and changes in the exchange rate regime. If ex ante real returns are not equal across countries and if these monetary regime changes systematically affect expected real returns, then similar changes should be observed in countries adopting similar policies.’ The evidence in this study does not support the existence of a systematic relation between monetary regime changes and changes in the behavior of ex ante real interest rates. Although expected real rates have not been constant across the policy shifts, the characteristics of changes in the real rate process exhibit substantial differences across countries. One explanation for the lack of a systematic relation between monetary regime changes and changes in the behavior of real rates is that monetary regime changes are neutral and the previous results observed for the U.S. spurious. An alternative explanation is that some countries did not implement their announced policy changes. In this case, differences in the behavior of real rates arise because policy changes in the four countries are not comparable. Some evidence on this explanation is obtained by testing whether announced policy changes reflect actual changes in monetary regimes. The tests indicate that differences in policy implementation do not fully explain differences in the behavior of real rates around similar monetary regime changes announced by the four countries. These results suggest that monetary regime changes associated with the adoption of monetary targets and exchange rate regime changes do not affect expected real returns. Other types of regime changes, however, may be nonneutral. For example, Huizinga and Mishkin (1986) suggest that the monetary policy change affecting the behavior of U.S. real rates in 1979 may have been the disinflationary policy that accompanied the change in operating procedures, rather than the change in operating procedures itself. While disentangling the separate effects of changes in operating procedures and changes in inflation policy is beyond the scope of this paper, such evidence will be important to resolving the issue of whether monetary regime changes are neutral with respect to ex ante real returns. The paper is organized as follows. Section 2 discusses the two types of monetary regime changes to be examined for each country, the adoption of 31f ex ante real returns are equal across countries, then monetary regime changes would have no effect m an open economy even if they were effective m a closed economy. Cumby and Mishkin (19861, Cumby and Obstfeld (19X4), Mark (1985). and Mishkin (1984a. b), however, reject the hypothesis that ex ante real returns are equal across countries,

332

C. Bower-Neal, Monetary regrme changes and the behavior of e.x ante real merest rates

monetary targets and changes in the exchange rate regime. Sections 3 and 4 test whether these monetary regime changes are systematically related to changes in the behavior of ex ante real rates. Section 3 tests the stability of the ex ante real rate process across regimes changes announced by each of the four countries, while section 4 examines whether the characteristics of the real rate process shifts are similar across countries. Section 5 examines whether the failure of the monetary authority to implement the announced change in policy can explain the observed differences in real rate behavior across countries. Conclusions are presented in section 6.

2. Monetary

regime changes

A monetary ‘regime shift’ is defined to occur when the monetary authority responds to economic shocks in a different way [Lucas (197611. Using this criterion, this study examines two types of monetary policy regime shifts common to Canada, Germany, the U.K., and the U.S. during the post-war period: the adoption of specific targets for the growth rate of domestic monetary aggregates and exchange rate regime changes. The adoption of monetary growth targets is a likely regime change because the targets, if binding, impose a constraint on the conduct of monetary policy. Previous research suggests that the Federal Reserve’s October 1979 decision to adopt a nonborrowed reserves operating procedure along with an emphasis on Ml growth targets was related to a change in the behavior of U.S. ex ante real rates. The shift from a fixed to a flexible exchange rate regime represents a second type of monetary regime change. Under fixed exchange rates, the monetary authority is constrained to maintain the exchange rate around its par value, while under floating rates, monetary policy can be used to pursue domestic objectives. While previous research finds significant differences in the behavior of real exchange rates across exchange rate regimes, the relation between the exchange rate regime and the behavior of real interest rates has not been examined.3 Table 1 summarizes the two types of monetary regime shifts examined for each country. The first type of monetary regime changes are those associated with the adoption or de-emphasis of monetary targets. New policies that emphasized monetary growth targets were announced in the United States in October 1979, in Canada in September 1975, in Germany in December 1974, and in the United Kingdom in July 1976. October 1979 is chosen as the effective date for the U.S. regime shift even though the Federal Reserve began to announce monetary growth targets in March 1975. This choice is ‘See, for example, Mussa (1985) on the behavior of real exchange rates across exchange rate regimes. In addition, Baxter and Stockman (1989) compare the behavior of mdustrial production, consumption, exports, and Imports across exchange rate regimes. They do not. however. examine the behavior of expected real interest rates.

C Bonser-Neal, Monetary regime changes and the behar,lor of ex ante real mlerest rates Table Monetary

Countr)

Monetary

Canada

(1) (2) (3) (4)

West Germany

( 1) Adopt flexible exchange

Umted

Umted

Kmgdom

States

1

regime shifts. Date

regtme shaft exammed

Adopt tixed exchange rates Adopt flexible exchange rates Emphasrze monetary targets Abandon monetary targets

(2) Announce monetary (3) Entry into European

333

rates targets Monetary

System

(1) Adopt flexible exchange rates (2) Announce monetary targets (3) Election of M. Thatcher wrth monetary

( 1) Adopt flextble exchange

platform

rates (2) Adopt non-borrowed reserve operatrng procedure + emphasis on monetary targets (3) De-emphasis of monetary targets + adopt borrowed reserves operatmg procedure

May May September November

1962 1970 1975 1982

March December March

1973 1974 1979

June July May

1972 lY76 1979

March October

1973 1979

October

1982

supported by evidence in Clarida and Friedman (1984), Hamilton (1988), Huizinga and Mishkin (19861, and Melton and Roley (1990) that suggests the Federal Reserve continued to emphasize interest rate over monetary targets until October 1979. The date for Canada corresponds to the month in which the change in policy was announced by the Central Bank, rather than to the date on which monetary targets were first announced.5 For Germany and the U.K., these regime change dates correspond to the dates on which the central banks began to publicly announce monetary growth targets.” The May 1979 election of Margaret Thatcher as Prime Minister is examined as an alternative date for the adoption of monetary targets in the U.K. because adherence to monetary targets and a reduction in the inflation rate were the primary goals of her monetary policy. Hence, the election of Thatcher could have altered both the implementation and the credibility of monetary targets after May 1979. Regime changes associated with the decision to de-emphasize or abandon monetary growth targets are also examined. Canada aban‘The Central Bank of Canada began to announce monetary growth targets in November 1975. On September 2. 1975, however. the Central Bank stgnaled a change in policy away from interest rate toward monetary growth targets by raising the Bank rate :‘% and by announcing that ‘control over the money supply cannot be mamtained unless the central bank is prepared to allow Interest rates to move’ (Bank of Canada, Rec,rew. October 1975, p. 24). ‘The first publicly announced monetary growth target for Germany was announced by the Central Bank Council of the Deutsche Bundesbank on December 5, 1974 (see the Monthly Report of the Deufsche Bundesbank. December 1974. p. 8). The first formal monetary growth target for the U.K. was announced on July 22, 1976 (see the Bank of England. QLlarterly Bulletm, September 1976, p. 307).

334

C. Bonser-Neal, Monetary regime changes and the behac,ror of ex ante real interest rates

doned monetary targets in November 1982, while the U.S. de-emphasized monetary targets in October 1982. Both Germany and the U.K. continued to announce monetary growth targets over the sample period. Exchange rate regime changes constitute the second type of regime change. The exchange rate regime changes examined are the adoption of fixed exchange rates in Canada (May 1962), and the adoption of flexible exchange rates in Canada (May 1970), Germany (March 19731, the U.K. (June 1972), and the U.S. (March 19731. Germany, however, did not allow the Deutsche mark to float against all currencies after 1973. Between 1972 and 1979, Germany maintained fixed par values between the Deutsche mark and other European currencies in the ‘Snake’, the precursor to the European Monetary System (EMS). Whether the March 1973 decision to float the Deutsche mark against the dollar and the December 1974 decision to adopt monetary targets represent effective changes in the monetary regime therefore depends upon the extent to which the Snake agreement imposed binding constraints on German monetary policy. Because countries periodically entered and abandoned the Snake, however, the credibility and viability of the arrangement may have been in doubt until the formal ratification of the EMS agreement in March 1979.’ Consequently, Germany’s entry into the EMS is examined as another potential exchange rate regime shift. The next two sections test whether decisions to adopt or abandon monetary targets and exchange rate regime changes are systematically related to changes in the behavior of ex ante real interest rates. Section 3 tests the null hypothesis that the ex ante real rate is stable across these monetary regime changes in the four countries, while section 4 tests whether real interest rates changed in the same way in countries announcing similar policy changes. These tests are conducted using data over the January 1965 to March 1986 period for the U.S., Germany, and the U.K., and over the January 1953 to March 1986 period for Canada. The longer sample period for Canada was chosen in order to analyze the 1962 exchange rate regime shift. A detailed description of the methodology and the data appears below. 3. Tests of the stability

of the real rate process

3.1. Estimates of the ex ante real rate In order to test the stability monetary regimes, identification

of the ex ante real rate process across assumptions must be imposed to extract

‘For example, France left the ‘Snake’ in 1974 and again in 1976. Formal discussions on a European monetary arrangement began in April 1978. In July, the European Counctl agreed that a zone of exchange rate stability was desirable. On December 6, 1978, the Council approved the basic prmcipals of a new monetary system. As described in Ludlow (1982). however, differences between member countries made the ratification of the agreement uncertain. The EMS formally began on March 13, 1979.

C. Bonser-Neal, Monetary regrme changes and the behaL)ior of ex ante real merest rates

335

estimates of the ex ante real rate from observable variables. Following the method employed by Mishkin (1981) and by Huizinga and Mishkin (19861, the ex ante real rate is estimated under two assumptions: first, expectations about inflation are rational and second, the ex ante real rate can be expressed as a linear projection onto an information set at time t. This method allows the ex ante real interest rate to be estimated within a multivariate framework and does not impose restrictions on the parameters of the time series process or on the correlations between the ex ante real rate and other economic variables.” Given these two assumptions, ex ante real interest rates are estimated as follows. The assumption that the unobservable ex ante real rate can be expressed as a linear projection onto an observable information set implies reI.1

=x,P + Uf,]’

where r-:1 is the expectation at time t of the real return on a nominally riskless asset with j months to maturity. X, is a 1 by k vector of observable variables in the information set. and U, J is the projection error. Ex post real rates differ from ex ante real rates by a forecast error: r f.J

=

re1.1 -Ft.,’

(2)

J is the realized rate of return on the asset held from time t to t + j the inflation forecast error realized at time t + j. Replacing r,:, in and eq. (2) with the projection (1) yields the regression equation

where

rr

‘1.1 1s

r I.1

=x,P + w,,,,

(3)

where w, J = ~1,J - .zr I’ Since both F,,] and II, J are orthogonal to the information subset iI, ordinary least squares yields’consistent estimates of p. The fitted values from this ex post regression yield estimates of the ex ante real rate, (CJ = x,p^. Testing the hypothesis that the behavior of the ex ante real rate is invariant to changes in the monetary regime involves testing whether the parameters in the vector p are constant before and after the regime shift. The ability of these tests to accurately reflect changes in the real rate process is likely to ‘An alternatrve method of estimating the ex ante real rate. the Kalman filter, on the other hand, Imposes such assumptions. Antonctc (1986) and Fama and Gibbons (1982). for example. assume the ex ante real rate follows a random walk and that the ex ante real rate and inflation processes are uncorrelated. While the evidence on whether the ex ante real rate contains a unit root is mixed [see Litterman and Wetss (1983) and Rose (1988)], there IS considerable evidence that the correlation between the ex ante real rate and expected Inflation IS significantly negative, rather than zero [see. for example, Litterman and Weiss (1983). Huizinga and Mishkin (1986). Mishkm (19Sl)l.

336

C. Bower-Neal, Monetary regime changes and the behactror of ex ante real mterest rates

depend on whether most of the information relevant to predicting the ex ante real rate is included in the regression. If relevant information is excluded from x,, then changes in p^ could reflect changes in the relation between X, and the left-out variables, rather than changes in the relation between the ex ante real rate and xc,.’ Several variables were therefore considered for inclusion in x,. Huizinga and Mishkin (1986) find that the nominal interest rate, lags of inflation, and a supply shock term are significant explanatory variables in ex post real rate regressions. The nominal interest rate is likely to reflect factors affecting the ex ante real rate which may be difficult to measure, such as expected inflation, while the supply shock term is likely to reflect changes in investment opportunities arising from the oil supply shocks of the 1970s. In addition, lagged nominal interest rates, growth rates of the money supply and industrial production, and changes in the import price index were considered for inclusion in x,. The change in the import price index is a proxy for international economic shocks which can affect the real interest rates of open economies. A complete description of the variables examined appears in appendix A. Parsimony required that only a subset of the variables considered be included in the final specification of the ex post real rate regressions. The variables included in x, for the U.S. are the annualized three-month nominal domestic interest rate, three lags of the annualized three-month U.S. inflation rate (x,_~,~, 7~,_~.~, and rr_9,3), and a supply shock variable.“’ The variables included in X, for Canada are the Canadian nominal interest rate and three lags of the Canadian inflation rate (T~_~.~, T~_~,~, and 7~,_,~,s).” For both Germany and the U.K., the domestic nominal interest rate, two lags of the domestic inflation rate (x,_~,~ and ~-~_,~.s), and the three-month change in the log of the import price index, are included in x,. Additional lags of inflation and lagged values of nominal interest rates, money supply growth rates and industrial production added little explanatory power to the ex post real rate regressions and so were excluded to conserve on degrees of freedom. Based on these specifications, the ex post real rate regression eq. (3) is estimated for each country over the subperiods identified in table 1. Ex post ‘Huizinga and Mishkm (1986) note that if the true projection IS rt, =X,Y +y,6 + u,,,, then the estimate of p in (6) will equal y + ah, where A equals the coetfictent on X, m a regresston of y, on xl. Smce p incorporates the informatron on the left-out variable. the OLS esttmate of r:, ~111 still be consistent. However, a change m p could arise from a change m y. 6, or A. Walsh (1988) argues that if x, includes the nominal Interest rate. then a change m a left-out vartable which affects the inflation process but not the real rate process will cause a change m A and hence in p. His example rmplicitly assumes, however, that the inflation process and the real rate process are uncorrelated. ‘“The measure of a supply shock is the same as that employed m Huizmga and Mishkin (1986). namely the three-month change tn the log of the ratio of the fuel component of the PPI to the overall PPI, i.e., ln(SS/PPI), - In(SS/PPI),_,. “The inflatton unadjusted CPI.

rate at lag 12 is hkely to reflect

the seasonal

induced

by usmg the seasonally

C Bower-Neal, Monetary regrtne changes and the behaL)lor of ex ante real interest rates

337

real returns are measured using end-of-month continuously compounded annualized nominal returns on domestic assets with three months to maturity and the continuously compounded annualized three-month inflation rate; hence, j = 3 in eq. (3X1’ The use of overlapping observations on three-month returns implies that the regression residuals, w,,,, are likely to be serially correlated at lags one and two. This correlation arises because the inflation forecast errors E,_ ,,3 and E,_,,~ are not realized at time r and hence can be correlated with E~ 3. Consistent standard errors which allow for serial correlation and conditional heteroscedasticity are estimated following Hansen (19821, and the resulting covariance matrix is used in Wald tests of the stability of the real rate process. 3.2. The stability of the real rate process Table 2 reports the results of Wald tests that the coefficients from (3) are are equal across monetary regimes. ” Two versions of the null hypothesis tested: one which restricts the intercept and slope coefficients to be equal across regimes and one which allows the intercept to vary. These tests provide evidence on whether a rejection of the null hypothesis is due to a shift in the mean of the ex ante real rate conditional on zero values for the information set variables or to a shift in the relation between the ex ante real rate and variables in the information set. This distinction becomes important when the characteristics of the real rate process shifts are compared across countries. The results show that ex ante real rate processes in the U.S., Canada, Germany, and the U.K. generally have not been constant across regimes.” The Wald tests indicate shifts in the ex ante real rate process after the announced adoption or de-emphasis of monetary targets in the U.S. (October “Because end-of-month nommal returns on three-month German interbank deposits were not available for Germany between 1965 and 1968, averages of daily data over the month were employed for thus perrod. Empnrcal tests of the hypothesis that the ex ante real return process is constant across monetary regimes were conducted both includrng and excluding the 1965-68 period. The results from tests excluding the 1965-68 period. available from the author on request, are similar to those reported below ‘“The first three observattons are dropped from each sub-period regression m order to prevent includmg inflation forecast errors from the previous period in the Wald tests. The coeffictent estimates from each subperiod regression are not reported but are available in an appendix from the author. “As noted earlier, the abthty of these tests to detect changes in the real rate process depends on whether most of the mformation relevant to predtcting ex ante real rates is included in the regression. Some evidence on whether the tests are affected by omitted variables can be obtained from the autocorrelations of the regresston residuals in (3). In particular, if most of the information relevant to predictmg the ex ante real rate IS included m x,. then the time series behavior of M’,,, will reflect primarily the behavior of the inflatron forecast errors and hence will follow an MAC21 process. The results indicate that the autocorrelations beyond lag two are largely insignificant. This provides evidence that the bias Induced by omitted variables is small if the omitted variables are serially correlated.

338

C, Bonser-Neal, Monetary regrme changes and the behavror of ex ante real interest rates

Table 2 Wald tests for parameter stability across monetary regimeP. Estimation periods

-.~

Country _.._-____ Canada

Regime change Adopt tixed exchange rates

-

Before regime change -.-___-.-_ 1954:4-1962:4

Adopt flexible exchange rates

--Germany

1962:8-1970:4

3.22 (0.67)

0.70 (0.95)

1970:8-1975:8

24.89 (0.00)

1.46 (0.11)

14.13 (0.01)

14.04 (0.01)

304.54 (0.00) .___ 52.66 KI.OO~

41.72 (0.00) 44.89 (0.00)

1970:8-197S:8

1975:12-1982:lO

Abandon monetary targets

1975:12-1982:lO

1983:2-1986:3

~.-1966:4- 1973:2

~_~ 1973:6-1974:ll

1966:4-1973:2

1973:6-1979:2

1.82 (0.87)

1.31 (0.86)

1975:3-19792

11.06 to.051

11.05 10.03)

57.31 (0.00) _ 22.25 (0.00)

37.67 (0.00)

Adopt flexible exchange rates

Announce monetaryb targets 1975:3-1979:2

19796-198633

--~ -1966:4-1972:5

___ ~_ 1972:9-1976%

Entry mto EMS ~. ______~_._.~_ Adopt flexible exchange rates

.-.-_.-

20.61 (0.00)

Announce monetary targets

1972:9- 1976:6

1976:10-1979:4

9.89 (0.081

3.09 (0.54)

Election of Thatcher

1976:10-19794

1979:8-1986:3

26.63 (0.00)

8.00 (0.09)

United States

Ha, X2

Emphasize monetary targets

Adopt flexible exchange rates

Umted Kingdom

Ha, XZ

After regime change

_~~

.-..-_

.~_

Adopt flexible exchange rates

1966:4-1973:2

1973:6- 1979:9

78.46 io.001

27.25 (0.00)

Emphasize monetary targets

1973:6-1979:9

1980: l-1982:9

42.89 (0.00)

27.62 (0.00)

De-emphasize monetary targets

1980:1-1982:9

1983:1-1986:3

30.26 (0.~)

28.95 (0.00) - _. ..__ aH,, IS the null hypothesis that all coefficients from the ex post real rate regresstons esttmated over the period preceding the regime change are equal to those estimated over the period following the regime change. H, is the null hypothesis only the slope parameters are equal across periods. The chi-square statistics are based on five (H,,f and four (H&f degrees of freedom for Canada, Germany, and the United Kingdom. For the U.S., the chi-square statistics are based on six (Ha,) and five (Haa) degrees of freedom. The significance levels are reported in parentheses below the chi-square statistics. hThe test statistic for the hypothesis that the parameters estimated over the 1973:6-1974:ll period are equal to those estimated over the t975:3-19792 period could not be calculated because the matrix was not positive definite.

C. Bower-Neal. Monetary regone changes and the behauor of ex ante real interest rates

339

1979, October 1982), in Canada (September 1975, November 1982), and in Germany (December 19741, but not after the July 1976 adoption of such targets in the U.K. The behavior of real rates in the U.K. does change after the election of Thatcher in May 1979, suggesting that the actual change in British monetary policy may have lagged the announced change. The adoption of flexible exchange rates is associated with a significant shift in the real rate process in the U.S. (March 1973) and the U.K. (June 1972) and with a change in the conditional mean of the ex ante real rate in Canada (May 1970). The evidence does not strongly support a change in the real rate process in Germany following the adoption of flexible exchange rates in March 1973; however, a significant change in the real rate process does occur after Germany’s March 1979 entry into the EMS.‘” Whether changes in the real rate process are caused by changes in the monetary regime cannot, of course, be determined from these tests. The result that ex ante real rates in all countries changed in the early 1970s and after 1979 is also consistent with the hypothesis that observed shifts of the real rate processes are due to common international economic shocks, such as the oil supply shocks of 1973 and 1979, or to common changes in the commitment to price stability, rather than to the changes in monetary regimes identified here. Alternatively, if Canada, Germany, and the U.K. are open economies with little influence over their own interest rates, then changes in U.S. monetary policy, rather than domestic policies, could be responsible for changes in the behavior of ex ante real rates observed in these countries. Some evidence on whether changes in ex ante real rates in the four countries occurred simultaneously is obtained by testing the null hypothesis that ex ante real rates in Canada, Germany, and the U.K. are constant across U.S. monetary regime changes in 1973, 1979, and 1982. These results, which appear in table 3, suggest that both the timing and the characteristics of shifts in the real rate process in Canada, Germany, and the U.K. differ from the timing and characteristics of shifts in U.S. expected real rates.lb In Canada. for example. the hypothesis that the Canadian ex ante real rate process is stable across the October 1979 change in U.S. monetary operating procedures is rejected. Unlike the U.S., however, the shift in the real rate ‘sin Germany. the hypothesis that the coefficrents estimated over the period of fixed exchange rates are equal to those estimated over the June 1973 to November 1974 subperiod following the adoptton of floating exchange rates IS also rejected; however. the coefficient esttmates in the latter pertod are based on very few observations. When the subperiod following the adoption of flexible exchange rates is extended through February 1979, the hypotheses that the real rate process is stable before and after March 1973 cannot be rejected. This suggests that the real rate process in Germany dtd not change around the adoption of flexible exchange rates m March 1973. “These results should be interpreted independent of those in table 7.

with caution.

however,

srnce the test stntrstrcs

are not

19x0:1-1982:Y

De-emphasize monetary targets

1983:1-1986:3

1980:1-1982~9

14.43 (0.01) 2.52 (0.64)

10.62 (0.06)

10.62 (0.03)

24.05 (0.00)

37.59 (0.00) 52.50 ~o.uot

13.94 (0.01)

XT

._____~

-._.

HO2

X2

-%I,

U.K.

1474 4.69 4.58 19.69 7.16 6.09 (0.01) (0.21) (0.19) (0.45) (0.33) GMO) _~_-_.-----___I -“-~-__-. ~.__...__ .-...- “~.------.--. aHo, is the null hypothesis that all coefficients m the ex post real mterest rate regressIons for Canada, Germany, and the U.K. are equal before and after the specified U.S. regime change; H,,, is the null hypothesis that only the slope parameters are equal across regime changes. The chi-square statistics are computed under five (I*,,,) and four (H,,,) degrees of freedom. Significance levels are in parentheses below the chi-squared statistics.

1973:6-1979:9

Wald tests for parameter stahihty across U.S. monetary regimes.” --.______I_-___ - -~_l___-__l Estimation periods Canada Germany _______._.__~ -___I__-___ --l___ Before regime After regime H I-i”, 112 %I Ho2 change change XZ X2 X2 X2 ._-_ ___ .-_ -I__... .---._ ..-_.____ _.-_ __~__ lY66:4-1973:2 1973:6-1979:9 48.23 2.41 0.45 2.50 (0.00) (0.98) (0.78j (0.65)

Emphasize monetary targets

U.S. regime change __. -._I ____ Adopt Rexible exchange rates

-____

Table 3

C. Bonser-Neal, Monetary regime changes and the behavior of ex ante real rnterest rates

341

process reflects a shift in the intercept, not a change in the relation between the ex ante real rate and variables in the information subset. Table 3 also shows that real rates in Germany and the U.K. were stable around the U.S. October 1982 decision to de-emphasize Ml targets, while real rates in the U.S. and Canada were not. Collectively, these results suggest that ex ante real rates in Canada, Germany, and the U.K. have not been perfectly correlated with the behavior of U.S. real rates. The next section examines how the real rate processes change through time to provide evidence on whether monetary regime changes are likely sources for observed differences in real rate behavior across countries. 4. Differences

in the behavior of expected real interest rates across countries

While the results from the previous section suggest that real rates have not been constant across regimes, they fail to characterize how the real rate process changed in each country. If monetary regime changes are systematically related to changes in the behavior of ex ante real rates, then, ceteris paribus, one should observe similar changes in the real rate processes in countries adopting similar policies. This section therefore examines the characteristics of changes in the real rate process across monetary regimes. In addition, Quandt tests are employed to access the accuracy of the regime breaks specified in table 1. 1.1.

Meau

and

1%ariances

Huizinga and Mishkin (1986) find that the October 1979 Federal Reserve regime shift toward an emphasis on monetary targets was accompanied by a rise in the level and variability of ex ante real rates. Whether this behavior is characteristic of other countries adopting monetary targets has not been examined. Figs. 1 to 4, which plot the predicted values of the ex post real rate regressions, do not support such a systematic relation. For example, the adoption of monetary targets was accompanied by a rise in the level and variability of ex ante real rates in the U.S. and Canada. but by a fall in the level and variability of ex ante real rates in Germany.” Because these estimates are based on a particular model for the ex ante real rate process, however, differences in the behavior of ex ante real rates across similar regimes could be due to the inappropriateness of the specification for a particular country. “For the U.S.. the variance of the estimated annualized ex ante real rates increases from 0.75% during the 1973:6-1979:9 period to 9.81% during the 1980:1-1982:9 period. For Canada the variance of the estimated ex ante real rate increases from 5.69% between 1970:8 and 1975:8 to 7.44% between 1975:12 and 1982:10, while in Germany the variance falls from 6.25% before 1974:12 to 2.64% between 1975:3 and 1979:2.

342

C. Bonser-Nenl, Monetary regrme changes and the behumor

ofexante real interest rates

-8 -10 -12 -14

i

-16f,

54

56

(

,

,

,

58

60

62

64

/

66

/

68

I

‘70

/

72

r

74

I,

76

b

78

80

1

82

t

84

’

Date Fig 1. Ex ante real mterest rate for Cattnda: Apnl 19.54 to March 1986. The ex ante real interest rate is estimated as the predicted value from the regresston of the annualized ex post real return on a three-month Treasury Bill onto an information set. The dotted lines indicate plus and minus two standard error bands around the estimate.

Alternative estimates of the mean of the ex ante real rate process can be obtained without a model of the ex ante rea1 rate process. In particular, if expectations are rational, then the mean of the ex ante real rate should equal the mean of the ex post real rate. These alternative estimates of the mean of the ex ante real rate appear in table 4. Estimates of the standard errors of the mean of the ex ante real rate, on the other hand, cannot be obtained without a model for either the expected real interest rate or the expected inflation rate. ” Instead, tests for the equality of means across monetary regimes employ the standard errors of the means of the ex post real rates. Since these standard errors will exceed those of the ex ante real rates, however, the tests will have low power against the ahernative that the means are not equal across monetary regimes.

‘sThe variance of the ex ante real rate can be rewntten as varWf = var(i) - COV(Z,P) cov(re,rre). where re is expected inflation [see Nelson and Schwert (1976)]. Consequently, estimating the variance of the ex ante real rate from observable variables requires an estimate of COV(P. a”).

C. Bonser-Neal, MonetaT regime changes and the behaclor of ex ante real interest rates 16

343

,

-10 -12 -14 -161 66

/ 67

, 68

, 69

, 70

, 71

, 72

, 73

, 74

, 75

, 76

, 77

, 78

Fig. 2. Ex unte real Interest rate for Germany: Aprd 1966 to March rate is estimated as the predicted value from the regression of the on a three-month interbank deposit onto an information set The minus two standard error bands around the

, 79

, 80

, 81

, 82

, 83

, 84

I 85

1986. The ex ante real interest annuahzed ex post real return dotted lines indicate plus and estimate.

The results in table 4 confirm the predictions of the ex post real rate regressions and indicate that changes in the means of expected real rates are not related to changes in monetary policy in a systematic manner. The adoption of monetary targets is associated with a rise in the mean of expected real rates in the U.S. and Canada, but with a fall in the mean of ex ante real rates in Germany. In addition, much of the increase in the Canadian real rate occurs between 1979 and 1982, rather than immediately following the adoption of monetary targets in 1975. For the U.K., the mean of the ex ante real rate increases after the election of Thatcher in 1979, but not after the announcement of monetary targets in 1976. Exchange rate regime changes also fail to be related to changes in the ex ante real rate in a systematic manner. Instead, the figures and table 4 suggest that the means of ex ante real rates in the four countries follow a similar trend through time: they are low before 1973, fall to lower and often negative values between 1973 and 1979, and then rise to high levels after 1980. These results are consistent with alternative explanations for changes in real rate behavior which focus on the effects of common international shocks.

344

C. Bower-Neal, Monetary regime changes and the behavior of ex ante real interest rates

-30

66

I1

67

68

I

69

t 70

, 71

, 72

, 73

I

74

I

75

I

76

I

77

r

78

1

79

I

80

IS

81

82

!

83

I

84

f

85

Date Fig. 3. Ex ante real mterest rate for the Umted Kmgdom: April 1966 to March 1986. The ex ante real interest rate is estimated as the predicted value from the regression of the annualized ex post real return on a three-month interbank deposit onto an information set. The dotted lines indicate plus and minus two standard error bands around the estimate.

4.2. Cross-correlations: The Mrmdell-Tobin between nominal and real rates

effect and the relation

Changes in real rate process can also be characterized by changes in the cross-correlations between expected real rates and variables in the information set. Huizinga and Mishkin (1986) find that the correlation between U.S. real and nominal interest rates rose during the 1979-82 period of monetary targets, while the Fisher effect became insignificant. They also find a significant negative correlation between the expected real interest rate and expected inflation within each subperiod. ~ishkin (1984bI finds a significant negative correlation between expected real rates and expected inflation in several countries before 1979, but does not examine the stability of this relation across monetary regime changes in those countries. An estimate of the relation between the expected real rate and expected inflation, often known as the ‘Mundell-Tobin effect’, can be obtained by regressing the ex post real rate on a proxy for the expected inflation rate.” Since the expectation of the inflation forecast error at time t is zero, a ‘“Mundell

(1963) and Tobm (1965) provide

an explanation

for this correlatton.

C. Bonser-Neal, Monetary regone changes and the behavior of ex ante real Interest rates

345

16 14 12 10 s6-

-4-6 -8 -

-16

,

1 66

, 61

, 68

, 69

I 70

I 71

I 12

I 73

I 14

, 75

I 76

, 77

I 78

I 79

I 80

I 81

I 82

I 83

I 84

I 85

Date Fig. 4. Ex ante real interest rate for the Unrted States: Aprd 1966 to March 1986. The ex ante real interest rate is estimated as the predicted value from the regression of the annualized ex post real return on a three-month Treasury Bill onto an information set. The dotted lines Indicate plus and minus two standard error hands around the estimate.

regression based on the ex post real rate should give the same results as a regression based on the ex ante real rate. Hence, if the true relation between the ex post real rate and the expected inflation rate is measured by PI in r 1.3

=

PO+ PPP,3+ 771.39

then, one can substitute rate to obtain

the realized

(4) for the unobservable

expected

inflation

(5) Because the composite error term, --P,E,,~ + vt,3 is correlated with the variables procedure must be used independent variable rrf. 3, an instrumental to obtain consistent estimates of the parameter PI. The procedure employed here is the two-step two-stage procedure proposed by Cumby, Huizinga, and Obstfeld (1983) which allows for the serial correlation induced by the overlapping inflation forecast errors. The instruments used in the estimation

346

C. Bonser-Neal,

Monetary regime changes und the behavior of ex ante real Interest rates Table 4 t-tests for equality

of means across monetary

Before Regime Canada

Germany

United Kingdom

change rfi

Dates

After regime change Dates

?;

t-test fe = pe n A

Adopt flexible exchange rates

1954:1-1962:4

1.49 (0.47)

1962:8-1970:4

1.76 (0.33)

Adopt flexible exchange rates

1962:8-1970:4

1.76 (0.33)

1970:8-1975:8

- 1.86 (0.86)

Adopt monetary targets

1970:8-19758

- 1.86 (0.86)

1975:12-1982:lO

2.37 (0.85)

3.50

U.S. adopts monetary targets

1975:12-1979:9

0.77 (0.73)

1980:1-1982:lO

4.53 (1.34)

2.46

Abandon monetary

1975:12-1982:lO

2.37 (0.85)

1983:2-1986:3

5.X6 (0.65)

2 60

Adopt flexible exchange rates

1965:4-1973:2

2.40 (0.63)

1973:6- 1974: 11

5.7x (0.91)

3.05

Announce monetary

1973:6-lY74:ll

5.78 (0.91)

1975:3-1979:2

0.68 (0.54)

- 4.80

targets

Announce monetary

lYh5.L1974:ll

2.85 (0.62)

1975:3-197912

0.68 (0.54)

- 2.65

targets

Entry into EMS

1975:3-1979.2

0.68 (0.54)

1979:6-1986:3

4.18 (0.47)

4.87

Adopt flexible exchange rates

1965:4-1972:5

1.90 (0.79)

1972:9-1976:6

- 4.50 (2.33)

- 2.60

Announce monetary

lY72:9-1976:6

- 3.50 (2.33)

1976:10-1979.4

- 1.44 (1 18)

1.17

1976:10-1979:4

-

3.90

Election Thatcher United States

change

regime

regimesa

targets

targets of

I .44 (1.18)

1979:8-19863

4.69 (1.04)

Adopt fextble exchange rates

1965:4-1973:2

1.06 (0.22)

1973%1979:9

- 1.73 (0.47)

Emphasize monetary targets

1973:6-197919

- 1.73 (0.47)

1980:1-1982:9

3 43 (1.46)

0.48 -3.94

-5.39 3.37

1980 l-1982:‘) 3 43 De-emphasize 1983:1-1986:3 5.19 1.16 monetary targets (1 46) (0.45) _ .~ “r-g (FL) is the mean of the ex ante real return on a three-month nominally riskless asset before (after) the spectfied regtme change, estimated as the sample mean of the ex post real return. The t-atattstics are calculated to test the null hypothesis that the mean of the ex ante real rate before the regime change is equal to the mean of the ex ante real rate after the regime change. The standard errors for the means of the ex post real interest rates are given m parentheses. and they are calculated using the result that the vartance of a serially correlated series is ‘n/N times the spectral density evaluated at frequency zero [Fuller (1976. ch. 6)1. The esttmate of 2rr ttmes the spectral density function used here is 3 R(O)

+ 2 c

R(J).

,=I

where

Rt

1) is the autocovartance

of the ex post real rate of lag j.

C. Bower-Neal, Monetary regime changes and the behactor of ex ante real merest rates

347

are the variables used to predict the real rate in the ex post regressions of section 3. Table 5 presents the two-step two-stage estimates of the relation between the expected real interest rate and expected inflation for each of the four countries. Consistent with previous research, the estimates reveal a negative relation between expected real returns and expected inflation in Canada, Germany, the U.K., and the U.S. In addition, the sign of this relation is not sensitive to announced changes in the monetary regime: expected inflation and ex ante real returns are negatively correlated across a variety of monetary policy regimes. Estimates of the relation between ex ante real and nominal interest rates are obtained from the slope coefficients in regressions of the ex post real rate on the nominal interest rate. These coefficient estimates, which also appear in table 5, once again fail to reveal similar behavior in countries experiencing similar changes in monetary regimes. Nominal and expected real rates were significantly negatively correlated in the U.S. prior to the emphasis on monetary targets in October 1979, but the relation became positive and significant during the 1979-82 period of monetary targeting. In contrast to the U.S., real and nominal rates in Canada were significantly positively correlated in periods prior to the adoption of monetary targets in 1975. In addition. this correlation remained positive and significant even after Canada’s decision to abandon monetary targets. The relation between the nominal and expected real rates in Germany was positive in all periods except during the April 1975 to February 1979 period following the adoption of monetary targets, while no significant relation is observed in the U.K. Consequently, the high positive correlation between real and nominal rates observed in the U.S. between 1979 and 1982, the period of monetary targeting, is not a feature common to countries announcing similar monetary regimes. 4.3. When did the real rate process change?

The Quandt

test

Comparisons of the behavior of real rates across monetary regimes discussed above are based on the assumption that any changes in the real rate process occurred around the monetary regime dates specified in table 1. If, however, the change in the real rate process did not occur on these dates, then such tests have reduced power. This section identifies the dates for the changes in the real rate process using a procedure developed by Quandt (1958, 19601. The Quandt test has been used by Huizinga and Mishkin (19861 and Antoncic (1986) in their tests for breaks in the real rate process and by Mankiw, Miron, and Weil (1987) in their examination of nominal rates around the creation of the Federal Reserve. Huizinga and Mishkin and Antoncic used nonoverlapping data when employing such a test. In the

348

C. Bonser-Neal, Monetary regime changes and the behaltior of ex ante real interest rates

of

(D) Untted

Umted

7.18 (0.43)

11.68 (0.40)

1.95 (0 77)

1.02 (0.72)

States

7.65 (1.22)

3 73 (1.27)

6.73 (1.16)

7.10 (0.54)

Kingdom

- 0.07 (0 11)

-087 (0.06)

- 0.45 (0.07)

- 0.002 (0 16)

-0.31 (0.16)

-04X (D 09)

- 0.74 (0.09)

- 0.94 (0 OX)

0.6’ (2.99)

-6.4X (3 76)

107 (1.X3)

- 0.66 (0.78)

Y.01 (4.54)

3.31 (2.55)

~ 1.93 (6.06)

-3.41 (4.00)

0.53 (0.34)

0.78 (0.26)

- 0.42 (0.26)

0.32 (0.14)

~ 0.33 (0.38)

- 0.48 (0.25)

- 0.23 (0.46)

0.70 (0.53)

“The coefficients in the regression of the ex post real rate on expected Inflation are estimated using the two-step two-stage procedure of Cumby. Huizmga, and Obstfeld (1983). The instruments used are the regressor, of the ex post real rate regressions of sectton 3. The coeffictents m the regression of the ex post real rate on the nomtnal interest rate are estimated uamg OLS. and the standard errors are computed allowmg for serial correlation following Hansen (1982). The dates of monetary regime changes are given in table 1.

After abandonment monetary targets 1983:1~1986:3

1980: 1 - 1982:Y

targets

After monetary

1966:419?3:2 1973:6-1979:9

rates

After flexible exchange rates/ Before monetary targets

Fixed exchange

19X6:3

1979%

After Thatcher’s

election

1976:lt_~lY79:4

After monetary targets/ Before Thatcher’s electton

1966:4- 19725 1972:9-lY76:6

rates

Flexible exchange rates/ Before monetary targets

Fixed exchange

(0

350

C. Bonser-Neal, Monetary regwne changes and the behaL:lor of ex ante real Interest rates

model presented here, however, serial correlation of the error term induced by the overlapping forecast errors requires a modification of the test. Under the assumption that a change in the real rate process has occurred, the Quandt test proceeds by finding the dates which minimize the sum of squared errors of the regression eq. (3). Based on the results of table 2, the Quandt test is used to identify the dates of two breaks in the real rate processes for Germany and the U.K. and three breaks in the real rate processes for the U.S. and Canada.‘” The objective function for the test is derived under the assumption that the serial correlation of the regression error term is dominated by the time series behavior of the inflation forecast errors. Given overlapping observations on three-month ex post real returns, this implies the regression error term follows an MA(2) process: w, = (1 - B,L - f3&‘)&

The log of the sum of squares residual function (LSSR), breaks, t, and t,, for a sample of size T, can then be written

assuming as

two

LSSR=t,*ln(sl)+(t,-t,)*ln(s2)+(T-t,)*ln(s3),

(7)

where sl = {;[, over the period t = 1,. . . , r,, s2 = [;.$? over the period t=t,+3,..., t2, and s3 = t;c3 over the period t = t2 + 3,. . . , T, and where t,, t2, and t3 are the white noise error vectors identified from a MA(2) process for the regression residuals for each subperiod. Overlapping periods are omitted to ensure independence. Estimating the log sum of squares for each period requires estimates of the 5,‘s j = 1,2,3. Consistent estimates of /3’s and of the 8’s can be used to obtain consistent estimates of the 6,‘s through an iterative estimation procedure.” Values of t, and t, which minimize (7) indicate the dates of changes in the ex ante real rate process. The dates which minimize eq. (7) differ from the regime change dates assumed for the Wald tests in section 3. For example, the dates which minimize the sum of squares for the U.S. ex post real rate regressions are “‘Due to the computational difficulty of solving for three breaks stmultaneously. the procedure below solves for only two breaks at a time. Specrfically, for the U.S., the Quandt test was used to find the first and the second breaks over the 1966:4-1982:9 period, and the second and the third breaks over the 1973:6-1986:3 period. For Canada. the Quandt test was used to find the first and the second breaks over the 1954:4-1982:lO perrod and the second and the third breaks over the 1970:9-1986:3 period. the 5,‘s can 2’Specifically, given consistent estimates of p. 0,. e2, t(O), and .$-l), estimated using the equation: 5, =y, -xlp + fI,.$_, + 8,[,_,. Consistent estimates of /3 given by the OLS estrmates. Consistent estimates of f3, and @a are obtained using autocorrelations of the least squares residuals at lags one and two and the procedure in Box Jenkins (1976). Finally, the mitral values. c(O) and [( - l), are assumed to be zero.

be are the and

C. Bonser-Neal. Monetary regone changes and the behavror of er ante real tnterest rates

351

1973:1, 1980:4. and 1982:11.‘* While the first and third dates are close to the regime change dates identified in table 1, the second break occurs six months after the October 1979 change in U.S. operating procedures. This result differs from the findings of Huizinga and Mishkin (1986), but is consistent with the results of Antoncic (1986). The dates which minimize the conditional sum of squares for Canada are 1970:10, 197.55, and 1982:12, while in Germany the sum of squares function is minimized around 1975:3 and 1978:12. The tests also show that the real rate process in the U.K. changed several months after the announced changes in monetary policy: the dates which minimize the sum of squares are 1973:12 and 1980:6. The Quandt tests suggest that changes in the real rate processes do not coincide with announced changes in the monetary regime. While these results could arise from timing differences between the announcement and the implementation of the regime change, the evidence is also consistent with the hypothesis that monetary regime changes are neutral with respect to real interest rates. These results, however, must be interpreted with caution for two reasons. First, the test is based on the assumption that the regression errors follow a stable MA(2) process within each subperiod. Second, the sum of squares function for each country is neither smooth nor monotonic and differences between LSSR’s are often small, suggesting that the dates of the change in the real rate process are not clearly defined.” Nevertheless, these results, combined with those of the previous sections, fail to provide convincing evidence of a systematic relation between monetary regime changes and changes in the behavior of ex ante real rates.

5. Promises

vs. actions: Some indicators

of a change in the monetary

regime

The results in section 4 indicate that ex ante real rates in the U.S., Canada, Germany, and the U.K. behave differently across similar announced monetary regime changes. One explanation for observed differences in real rate behavior is that some countries did not implement their announced policy changes; hence, monetary regime changes may not be directly comparable across countries. This section therefore examines whether announced policy changes reflect actual changes in the monetary regime. The tests below focus on the announcement of monetary targets and Germany’s entry into the EMS since the regime changes from fixed to flexible exchange rates in Canada, the U.K., and the US. are less controversial. “The 1980:4 breakpomt results from applying the Quandt test to the 1966:4-1982:9 period. Minimizing the log sum of squares functton over the 1973:6-1986:3 period resulted m a breakpoint in June 1980. Estimates of LSSR for the U.S. and other countries are available in an appendix from the author. z’In addition, simulations in Roley and Wheatley unrehable in correctly identifymg breaks.

(1990) suggest

that the Quandt

test may be

352

C. Bower-Neal, Monetary regrme changes and the behat,ror of ex ante real Interest rates

An ideal test for a change in the policy regime would involve estimating the monetary authority’s known policy reaction function and testing the stability of reaction coefficients across regimes. Unfortunately, the policymaker’s reaction function is not observed. Instead, the implications of regime changes for reduced-form economic relations are used to construct two indicators of changes in the monetary regime. First, sample statistics on money supply growth rates and nominal interest rates are compared across reported regime changes. All else constant. the volatility of the money supply under a regime that adheres to growth rate targets is expected to be less than or equal to money supply growth volatility under a regime without such targets. Mascaro and Meltzer (19841, Melton and Roley (19901, and Walsh (1984) show that interest rate volatility, on the other hand, will tend to be higher under an operating procedure that targets reserve aggregates than under a procedure that targets nominal interest rates. Baxter (1989) notes more generally that interest rate volatility can increase if a change in the monetary rule induces uncertainty. Sample statistics therefore can provide some information on whether announced regime changes were implemented. Second, following Neftci and Sargent (1978) and Chan (1988), the stability of a reduced-form monetary policy feedback equation is examined across monetary regimes. A reduced-form policy feedback equation that relates the growth rate of the money supply to its own past values and to past values of income is estimated for each country: L

DM, = Po +

c P,,DKI ]=I

L

+

c P$-,

+ ll,,

J’I

where DM, is the monthly change in the logarithm of the money supply being targeted and Y, is the logarithm of industrial production.‘4 The Akaike criterion is used to determine the number of lags, L, to include for each country.15 All else constant, a change the monetary authority’s reaction function will cause a change in the parameters of (8). The null hypothesis that the equation parameters are constant across announced changes in the monetary regime is therefore tested to provide evidence on the effectiveness of the policy change. “‘Seasonal dummtes are mcluded in the equations for Canada and the U.K.. but they are assumed to remain constant across regimes. Seasonals were not stgnificant in the equations for the U.S. and Germany, and so they are not mcluded m the results below. “The Akatke crtterion is apphed to each monetary regtme subperiod. For the U.S., Germany. and the U.K., the lag length chosen was the maximum lag length indicated by the subpertod tests. This lead to choices of L = 1. L = 3, and L = 1, for the U.S., Germany, and the U.K., respectively. For Canada, the tests indicated a lag length of 11. In order to obtain a parsimonious representation, however, L was taken to be 3. Spectfications with higher lags yield similar results to those reported below.

C. Bonser-Neal.

Monetup

regrme changes and the behauor

of ex ante real interest rates

353

Table b Tests for a change

m the monetary

regime

(A) Canada 1970:8-1975:81975:2-1982:101983:2-1986:31975:12-1979:91980:1-1982:10 Before monetary targets

Adopt monetary targets

Abandon monetary targets

Before U.S regime change

After U.S. regime change

Statist& DM,

Mean Std dev.

0.008 0.015

0.004 0.028

0.016 0.033

0.005 0.021

0.004 0.037

I I.3

Mean Std. dev

5.364 1.856

11.714 3.797

10.136 1 122

8.938 1.427

15.281 2.961

JI ,.3

Mean Std. dev

0.036 0 387

0.033 0.927

Il.017 0 628

0.070 0.253

- 0.074 1.384

-

13.80 (0.055)

_

19.46 (0.01)

Stability of monetary feedback equation parametersh 46.02 (0.00)

(B) Germany 1970:1-1974:ll

1973 5-1979:2

Before monetary targets

Adopt monetary targets

1979:6-1986

Enter EMS

Statistics” DM,

Mean Std. dev.

0.007 0.005

0.007 0.006

0.004 0.003

11.3

Mean Std. dev.

8.Y52 2.765

4.170 0.458

7.895 2.629

Jlr.3

Mean Std. dev.

- 0.006 0.829

- 0.044 0.246

- 0.022 0.730

3.07 (0.01)

5.39 (0.00)

Stability of monetary feedback equation parametersh F-statistic

(C) United 197219%1976~7

Kmgdom 1976:10-1979:4

Before monetary targets

Adopt monetary targets

1979:8-1986:3 Election of M Thatcher

Statistics” DM,

Mean Std. dev.

0.011 0.016

0.008 0.013

0.010 0.012

I 1.3

Mean Std. dev.

11.509 2.313

9.944 2.929

12.913 2.643

3

354

C. Bonser-Neal, Monetary regime changes and the behaclor of ex ante real mterest rates Table 6 (continued) (0

United

Kingdom

(continued)

1972:9-1976:7

1976:10-1979:4

Before monetary targets

Adopt monetary targets ~-

1979:8-1986:3 Election of M. Thatcher

StatistIcsa

Al,,3

Mean Std. dev.

0.086 1.182

- 0.026 1.057

- 0.037 0.938

1.12 (0.35)

0.86 (0.47)

Stabihty of monetary feedback equation parametersh F-stattstic

(D) Untted

States

1973:6-1979:9

1980:1-1982:Y

Federal funds rate target

Monetary targets emphasized

lY83:1-lY86:3 Monetary targets de-emphasized

Statistics” DM,

Mean Std. dev.

0.005 0.004

0.005 0.008

0.007 0.004

i 1.3

Mean Std. dev.

6.798 1.645

12.415 2.416

8.479 1.128

Jl ,.s

Mean Std. dev.

0.430 0.617

PO.137 1.541

- 0.041 0.327

15.79 (0.07)

16.25 (0.06)

Stability of monetary feedback equation parametersb

x

“DM, IS the first dtfference of the logartthm of the monthly money supply bemg targeted (U.S.-Ml. Canada-Ml, Germany-Central Bank Money, U.K.-Sterling M3); i,,, 1s the annualtzed three-month nominal domestic return; Jr,, s is the first difference of the nommal interest rate. hTest of the equality of the parameters of L

DM,=P,,+

L

zP,DM,-,+ c&J-,+u, ,=I

,=I

across monetary regimes. The number of lags, L. is determined by the Akaike criterton for each country. For the U.K., L = 4; Canada, L = 3; Germany. L = 3; the U.K.. L = 1. Seasonal dummies are mcluded in the equation for Canada and the U.K., but these were assumed to remain constant across regimes. In addition, the standard errors in the equations for the U.S. and Canada are estimated allowmg for condttional heteroscedasticity following White (1980); consequently xz statistics are reported for tests of parameter equality. The error terms m the equations for Germany and the U.K. appear conditionally homoscedastic so F-statistics are reported.

C. Bonser-Neal, Monetaty regune changes and the behavror of ex ante real merest rates

355

The two indicators of changes in the monetary regime, presented in table 6, yield mixed results. Statistics on the growth rate of the money supply cast doubt on whether the announcement of monetary targets corresponded to realized changes in the monetary regime. The variability of money supply growth in Canada and the U.S. was higher, rather than lower, during the period of monetary targeting. In Germany and the U.K., money supply growth volatility appears unaffected by the announcement of monetary growth targets. This evidence is consistent with the view that the adoption of monetary growth targets was hindered by the unwillingness or the inability of the central banks to adhere to such targets. Statistics on the variability of nominal interest rates, on the other hand, provide some indication of monetary regime changes in the U.S., Canada, and Germany, but not in the U.K.‘h The increase in the variability of nominal interest rates in the U.S. and Canada following the adoption of monetary targets is consistent with a new policy to stabilize money supply growth rather than interest rates. Since the increase in interest rate volatility in Canada occurred after 1979 rather than after the announcement of monetary targets in 1975, however, the implementation of the new regime may have been lagged the announcement. In contrast to the U.S. and Canada, the variability of nominal interest rates in Germany fell after the adoption of monetary targets in 1974. Because Germany did not explicitly target interest rates prior to 1974, this decrease in nominal interest rate volatility is consistent with a monetary target regime and may reflect Germany’s decision to emphasize monetary growth stability over exchange rate stability.” Changes in the parameters of the monetary policy feedback eq. (8) provide another indicator of changes in the monetary regime. For the U.S., Canada, and Germany, the results are consistent with the hypothesis that announced policy changes were indeed realized. The hypothesis that the parameters are stable after the adoption or de-emphasis of monetary targets is rejected at less than the 10% level for all three countries. In addition, the hypothesis that the monetary policy feedback equation is stable after Germany’s entry into the EMS is also rejected at less than the 1% significance level. The policy feedback parameters in the U.K., on the other hand, are stable after the 1976 decision to announce monetary targets in the U.K. and after Thatcher’s election in 1979. Overall, these indicators do not provide strong support for the hypothesis that differences in the behavior of U.S., Canadian, and German ex ante real interest rates are due solely to policy implementation differences across

“Statlstlcs levels appear “See, targeting

on both the level and the first difference nonstationary.

for example, and interest

Svensson (1989) for a dlscussion rate variability.

of nominal

rates are presented

of the relation

between

since the

exchange

rate

356

C. Bonser-Neal, Monetary regwne changes and the behavror of ex ante real interest rates

countries. The instability of the monetary policy feedback parameters and the behavior of nominal interest rate variability are consistent with the adoption of monetary targets in the U.S., Canada, and Germany, and with a change in the monetary regime following Germany’s entry into the EMS. For the U.K., however, the evidence suggests that announced monetary targets were not effectively implemented: the indicators appear stable across both the 1976 and the 1979 reported changes in monetary policy. Policy implementation differences may help explain why U.K. and U.S. real rates behave differently across apparently similar regime shifts.2x

6. Conclusion Previous research suggests that U.S. monetary regime changes have been important factors affecting the behavior of real interest rates. Determining whether monetary regime changes are systematically related to changes in the behavior of ex ante real rates requires a larger sample of regime changes, however. This paper extends previous research by comparing the effects of monetary regime shifts that have been announced in Canada, Germany, the U.K., and the U.S. If monetary regime changes affect the behavior of ex ante real returns in a systematic manner, then, ceteris paribus, similar changes in real rate behavior should be observed in countries experiencing comparable changes in monetary policy. This study, however, finds significant differences in the behavior of ex ante real rates across apparently similar monetary regime shifts in the four countries. Three explanations can be offered for these results. First, monetary policy changes may be neutral and the previous relations observed for the U.S. spurious. Instead, other economic factors may be responsible for observed changes in real rate behavior in the U.S. and abroad. Second, the relations between real rates and monetary regimes may differ across countries because the policy changes examined here are not directly comparable. For example, differences in the implementation of policy changes can lead to differences in real rate behavior. In an attempt to distinguish between the first two explanations, two indicators of changes in the monetary regime were examined. These indicators yield mixed results, but they suggest that observed differences between the behavior of ex ante real rates in the U.S.. Canada, ‘“Mankiw and Miron (1986) suggest that changes m the coeffictent from the regression of future changes in short-term interest rates on the slope of the yteld curve may provtde another indtcator of monetary regime changes. Using stx- and three-month interest rates for the U.S.. Canada. and Germany and three- and one-month rates for the U K., the hypotheses that the relatton between the slope of the yteld curve and future changes m interest rates IS stable across regtmes was never rejected. As noted by Hardouvelis (1988). however, a problem with these tests IS that the coefficient from such a regression will retlect the ratio of the variation m the expected change in the interest rate to the variation of the term premium. Because the effect of a regime change on this ratto IS unclear. these tests are likely to be uninformative. I am grateful to the referee for this point.

C. Bonser-Neal,

Monetary

regme changes and the behavior

of ex ante real interest rates

357

and Germany are not attributed solely to differences in the implementation of announced policy changes. A third explanation for the observed differences in the behavior of ex ante real rates across monetary regimes focuses on whether the regime changes analyzed here are economically significant. Huizinga and Mishkin (1986), for example, suggest that the monetary policy changes of economic importance may not be those associated with changes in operating procedures; rather, the policy change affecting the behavior of real rates in the U.S. may have been the disinflationary policy announced by the Federal Reserve after 1979. Future research to determine the effects of alternative types of monetary regime changes, such as those defined by changes in inflation policy, is therefore necessary to provide evidence on this third explanation for observed changes in the behavior of ex ante real rates across time as well as differences in real rate behavior across countries. Appendix: A.1.

Data sources

Interest rates

United States: Federal Reserve Bank of New York, end-of-month three-month Treasury Securities from 1965:l to 1986:3. Bank of Canada, Statistical Summary and Canada: Reriew. various issues, end-of-month data on three-month ties from 1954:l to 1986:3.

data on

Bank of Canada, Treasury Securi-

Germany : Deutsche Bundesbank. Monthly Report of the Deutsche Bundesbank, averages of daily interest rates on three-month interbank deposits sampled over a month from 1965:l to 1968:12; Morgan Guaranty’s World Financial Markets, end-of-month interest rates on three-month interbank deposits from 1969:l to 1986:3. United Kingdom: Bank of England, Statistical Abstract, and the Quarterly Bulletin, various issues, end-of-month interest rates on three-month interbank deposits from 1965:l to 1986:3. A. 2. Prices United States: Department of Labor, Bureau of Labor Statistics; consumer price index (seasonally unadjusted), producer price index (seasonally unadjusted), fuel component of PPI (seasonally unadjusted). Canada: unadjusted).

Bank

of Canada,

Germany: International unadjusted).

Monthly Financial

Reriew:

consumer

price

index

(seasonally

Report of the Deutsche Bundesbank (1965-69) and Statistics (1970-86): consumer price index (seasonally

358

C. Bower-Neal. Monetary regme changes and the behac,for of ex ante real Interest rates

United Kingdom: Central Statistical Office, Great Britain, of Statistics: consumer price index (seasonally unadjusted).

A.3.

Digest

Money supplies

United States: Canada: International

Ml, not seasonally

Ml, not Financial

seasonally Statistics.

adjusted,

adjusted,

Federal

United Kingdom: Quarterly Bulletin.

Sterling

Reserve

International

Germany : Central Bank Money, seasonally nomic Indicators: Historical Statistics 1968-88.

A.4.

Monthly

M3, not seasonally

adjusted,

adjusted,

Board.

Monetary

OECD,

Fund,

Main Eco-

Bank of England,

Other L!ariables

Data import and export price indices and industrial from International Financial Statistics, various issues.

production

were taken

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