It is generally believed that monetary policy actions are transmitted to the economy through their effect on market interest rates. According to this standard view, a restrictive monetary policy by the Federal Reserve pushes up both short-term and long-term interest rates, leading to less spending by interest-sensitive sectors of the economy such as housing, consumer durable goods, and business fixed investment. Conversely, an easier policy results in lower interest rates that stimulate economic activity.
Unfortunately, this description of the monetary policy process is difficult to reconcile with the actual behavior of interest rates. Although casual observation suggests a close connection between Federal Reserve actions and short-term interest rates, the relationship between policy and long-term interest rates appears much looser and more variable. In addition, empirical studies that attempt to measure the impact of policy actions on long-term rates generally find only a weak relationship. Taken together, the empirical studies and the observed behavior of interest rates appear to challenge the standard view of the monetary transmission mechanism and raise questions about the effectiveness of monetary policy.
This article attempts to reconcile theory and reality by reexamining the connection between monetary policy and long-term interest rates. Using a framework that emphasizes the importance of market expectations of future monetary policy actions, the article argues that the relationship between policy actions and long-term rates is likely to vary over the business cycle as financial market participants alter their views on the persistence of policy actions. Accordingly, the standard view of the monetary transmission mechanism appears to provide an overly simplistic view of the policy process. In addition, by capturing the tendency of market rates to anticipate policy actions, the article finds a larger response of long-term rates to monetary policy than reported in previous research.
The first section of the article describes the standard view of the monetary transmission mechanism and examines its consistency with actual interest rate behavior. The second section uses the expectations theory of the term structure to show how the impact of monetary policy on long-term rates depends on market expectations about the future direction of policy. The third section presents new empirical estimates of the relationship between policy actions and long-term rates.
MONETARY POLICY AND LONG-TERM RATES: THEORY VS. REALITY
The standard view of the monetary policy transmission mechanism suggests a close relationship between Federal Reserve policy actions and market interest rates. However, while there is considerable evidence that monetary policy has predictable effects on short-term rates, the connection between policy actions and long-term rates appears to be weaker and less reliable.
The monetary transmission mechanism
Changes in the stance of monetary policy take place in the market for reserves held by depository institutions. The Federal Reserve can alter the supply of reserves either by using open market operations to buy or sell government securities or by altering the amount of reserves borrowed through the discount window. Providing fewer reserves than desired by depository institutions puts upward pressure on the price of reserves--the federal funds rate--while supplying more reserves than institutions desire puts downward pressure on the funds rate.
In recent years, the Federal Reserve has implemented monetary policy by using open market operations to maintain a desired level of the federal funds rate (Lindsey). This "short-run operating target" is derived from longer term objectives for price stability and economic activity, and is adjusted when the Federal Reserve believes the stance of policy should be altered to better achieve its long-run objectives …