How Do Anticipated Changes to Short-Term Market Rates Influence Banks' Retail Interest Rates? Evidence from the Four Major Euro Area Economies

Much of the literature on interest rate pass through assumes banks set retail rates by observing current market rates. We argue instead that banks anticipate the direction of short-term market rates when setting interest rates on loans, mortgages and deposits. If anticipated rates - captured by forecasts of short-term interest rates or future markets - are important, the empirical specifications of many previous studies that omit them could be misspecified. Including such forecasts requires a detailed consideration of the information in the yield curve and alternative forecasting models. In this paper we use two methods to extract anticipated changes to short-term market rates - a level, slope, curvature model and a principal components model - at many horizons, before including them in a model of retail rate adjustment for four interest rates in four major euro area economies. We find a significant role for forecasts of market rates in determining interest rate pass through; alternative specifications with futures information yield comparable results. We conclude that it is important to include anticipated changes in market rates to avoid misspecification in pass through estimation.