REGIME-SWITCHING IN AUSTRALIAN SHORT-TERM INTEREST RATES

This paper applies a generalized regime-switching (GRS) model of the short-term interest rate to Australian data. The model allows the short rate to exhibit both mean reversion and conditional heteroscedasticity and nests the popular generalized autoregressive conditional heteroscedasticity (GARCH) and regime-switching specifications. It is shown that empirical estimates of many popular interest rate models provide curious results which imply that innovations to the short rate process are extremely persistent, and that the short rate is potentially non-stationary. The source of these curious results, which are also present in US and European interest rates, is identified in the context of the GRS model, which is shown, via specification and forecasting tests, to capture the features of Australian short-term interest rate data better than existing models. The stochastic process of short-term interest rates in Australia is compared with evidence from the US and Europe, highlighting a number of important differences.