The dynamic relationship between the euro overnight rate, the ECB's policy rate and the term spread

Abstract

This paper investigates how the dynamic adjustment of the European overnight rate Eonia to the term spread and the ECB's policy rate has been affected by rate expectations and the operational framework of the ECB. In line with recent evidence found for the US and Japan, the reaction of the Eonia to the term spread is non-symmetric. Moreover, the response of the Eonia to the policy rate depends on both, the repo auction format and the position of the Eonia in the ECB's interest rate corridor. Reserve, the interbank money market for overnight lending is the key channel through which monetary policy is executed. Overnight rates are the operational target of monetary policy that anchors the term structure of interest rates. Understanding the determinants and the dynamics of the overnight rate is therefore of crucial importance for implementing monetary policy in an efficient way. This paper investigates how the dynamic adjustment of the European overnight rate Eonia to the term structure and the ECB's policy rate is affected by rate expectations and the operational framework of the ECB. KeywordsOur empirical setup for the analysis of the overnight rate dynamics emphasizes the role of two separate relations driving the long-run behavior of the Eonia. One major determinant of the level of the overnight rate is the central bank's policy rate defined as the repo rate set in the ECB's main refinancing operations. A second long-run relation is suggested by the expectations hypothesis of the term structure which implies that the Eonia adjusts to the difference from a longer-term interest rate. Our empirical model incorporates both effects, taking account of persistent deviations of the Eonia from the policy rate at the end of the monthly reserve maintenance period. These deviations are found to represent a counterintuitive reaction of the Eonia to rate change expectations, which can be explained by the disturbing influence of banks' under-and overbidding on the interbank market in the period before the ECB reformed its operational framework in Similar to the US Federal funds rate target, the ECB's fixed repo rate seems to be a symmetric policy rate. In contrast, one might expect that a minimum bid rate, as applied by the ECB since June 2000, is particularly effective in defining a lower bound for interest rates. Furthermore, the under-and overbidding episodes in the ECB's main refinancing operations suggest that also the direction of expected rate changes affected Eonia dynamics.We therefore extend our base model and allow for non-symmetric adjustment to both longrun relations, taking account of potential influences from monetary policy implementation by the ECB. In particular, we investigate how the dynamic adjustment of the Eonia to its long-run determinants depends on the June 2000 change in the auction format of the ECB's main refinancing operations.Our results indicate that the dynamics of the Eonia within the monthly reserve maintenance period depend on the auction format. Interestingly, the introduction of v...

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