The Term Structure of Interest Rates in a Heterogeneous Monetary Union

Series: Featured research.

Author: James Costain, Galo Nuño, and Carlos Thomas.

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The Term Structure of Interest Rates in a Heterogeneous Monetary Union (205 KB)

Summary

We build a structural model of yield curves in a monetary union where the central bank’s bond purchases affect the probability of peripheral default. A euro area calibration shows that asset purchases affect peripheral yields mainly through “default risk extraction”, whereby purchases reduce both the amount of sovereign risk that the market must absorb, and the probability of sovereign default. Counterfactual simulations show that the PEPP’s flexibility enhanced its effectiveness, contributing approximately 15bp to the overall 80bp impact of the initial PEPP announcement on Italian yields, without changing German yields. Flexibility could again prove valuable in future ECB asset purchase programs, if the smooth transmission of monetary policy to all euro area countries is compromised by unwarranted fragmentation.