Academic journal article Journal of Money, Credit & Banking

Monetary Policy and the Term Structure of Interest Rates in Japan

Academic journal article Journal of Money, Credit & Banking

Monetary Policy and the Term Structure of Interest Rates in Japan

Article excerpt

THIS PAPER INVESTIGATES the relationship between the Japanese yield curve and monetary policy. In the 1980s and 1990s average bond yields have risen from 5% to 8% and then fallen to 2% and the slope of the yield curve has swung from positive to negative to positive. We are interested in understanding the contribution of monetary policy to these movements in the yield curve.

One motivation for our interest is Japan's recent experience. In spite of massive increases in monetary base and a zero nominal interest rate, economic growth has remained low and deflationary pressure has not abated. These events are raising new questions about the effectiveness of monetary policy under a zero nominal interest rate policy. Eggertson and Woodford (2003) argue that a monetary authority can still influence economic activity when nominal interest rates are zero by taking actions that affect market expectations about the future time path of variables such as interest rates, inflation or exchange rates. One way to assess the ability of a central bank to affect expectations is to look retrospectively and ascertain the extent to which previous monetary policy surprises have affected bond yields of different maturities. If monetary policy is indeed a potent tool for altering expectations then this should show up in the responses and variance decompositions of medium and long-term bonds yields to suitably identified shocks to monetary policy.

In order to isolate the effects of monetary policy on the yield curve we must first identify monetary policy shocks. Our strategy for identifying monetary policy combines zero restrictions as in Christiano, Eichenbaum, and Evans (1996), Bernanke and Mihov (1996), Leeper, Sims, and Zha (1996), Miyao (2002), and Shioji (1997) with sign restrictions on the impulse response functions as in Faust (1999) and Uhlig (1999). An advantage of our empirical strategy is that it is straightforward to investigate the robustness of any conclusions to the maintained assumptions about how monetary policy affects the macro-economy.

We consider two distinct maintained hypotheses. The liquidity, effect hypothesis maintains that a surprise tightening in monetary policy increases short-term nominal interest rates, and lowers output, prices, and monetary aggregates. This hypothesis reflects the consensus view about how monetary policy affects the U.S. economy [see e.g. the recent survey article by Christiano, Eichenbaum, and Evans, 1999]. We also consider the costly price adjustment hypothesis. This hypothesis maintains that a surprise tightening in monetary policy lowers interest rates, money supply, output, and prices. It is consistent with the implications of costly price adjustment models with monopolistic competition as in: Rotemberg (1996), Christiano, Eichenbaum, and Evans (1997), Ireland (1997), and Aiyagari and Braun (1998). Braun and Shioji (2002) find that Japanese data are more consistent with the costly price adjustment hypothesis. Here we report results under each of the two maintained hypotheses in order to compare their implications for the Japanese yield curve.

The choice of maintained hypothesis has important implications for the interaction of monetary policy and the yield curve. Under the liquidity effect hypothesis innovations in monetary policy have highly transient effects on short-term interest rates and the slope and curvature of the yield curve. Moreover, monetary policy shocks only account for a small fraction of the long-run variance in yields. Under the costly price adjustment hypothesis, in contrast, there is a rich set of interactions between monetary policy and the yield curve. Monetary policy shifts the level of the yield curve and produces large hump-shaped responses in yields of all maturities. Monetary policy also accounts for a substantial fraction of the long-term variance in long-term yields.

Our analysis is related to recent work by Ang and Piazzesi (2003) and Evans and Marshall (2001). …

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