The term structure of interest rates in Australia: An application of long run structural modelling

The term structure of interest rates in Australia, using data of different types as well as frequencies covering the period 1991(11) to 2000(9) is investigated using a relatively new modelling strategy previously untested on Australian interest rate data. Developed by Pesaran and Shin (2002), this strategy incorporates long-run structural relationships in an otherwise unrestricted vector autoregression model (VAR). The econometric tests indicate that in Australia, contrary to popular belief, long-term interest rates more often than not lead shorter-term interest rates, at least for the interest rates and time period under investigation. While these findings are not conclusive, if they are accurate representation of interest rate behaviour, this does pose a major challenge for the monetary policy in Australia. The findings are consistent with the recent experience of the USA as well (Sarno and Thornton, 2003). The findings of the study based on recent rigorous time-series techniques tend to cast doubts on the efficiency and effectiveness of current monetary policy in Australia.