The European Central Bank published a Working Paper (No 3048) examining how volatility in euro area short-term money market rates affects the transmission of monetary policy, finding that higher short-rate volatility weakens the impact of monetary policy shocks on output and prices. The paper links this effect to earlier stages of the transmission mechanism, with bank lending rates and loan volumes becoming less responsive when non-policy-related short-rate volatility is elevated. Using monthly data from January 2002 to February 2020 and high-frequency monetary policy shocks identified from changes in the 1-month OIS rate around ECB press conferences, the authors measure short-rate volatility within reserve maintenance periods using EONIA (until October 2019) and the euro short-term rate (€STR) thereafter. Exogenous shifts in volatility are identified via pronounced heteroskedasticity associated with regime changes in the ECB’s operational framework and liquidity conditions, and the estimates suggest that at the trough the GDP and GDP deflator responses to a given policy shock fall by around half for each one-standard-deviation increase in short-rate volatility. Robustness checks including controls for excess liquidity, alternative instrumentation choices, and tests that merge implementation regimes leave the main results broadly unchanged, and the paper concludes that keeping short-rate volatility within reasonable bounds can support transmission, while noting trade-offs with preserving money market activity.
European Central Bank 2025-04-02
European Central Bank working paper finds higher short-term rate volatility dampens monetary policy transmission
The European Central Bank's Working Paper (No 3048) finds that increased volatility in euro area short-term money market rates weakens the transmission of monetary policy shocks on output and prices. Using data from January 2002 to February 2020, the study shows that higher short-rate volatility reduces the responsiveness of bank lending rates and loan volumes. The paper concludes that maintaining short-rate volatility within reasonable limits supports monetary policy transmission, despite potential trade-offs with money market activity.