Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Expectations and the Monetary Policy Transmission Mechanism

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Expectations and the Monetary Policy Transmission Mechanism

Article excerpt

"For successful monetary policy is not so much a matter of effective control of overnight interest rates as it is of shaping market expectations of the way in which interest rates, inflation, and income are likely to evolve over the coming year and later. "

-Michael Woodford

In principle, the monetary policy transmission mechanism can be described rather simply. When the Federal Reserve raises its target for the federal funds rate, other interest rates also rise-reducing interest-sensitive spending and slowing the economy. Conversely, when the federal funds rate target is lowered, other interest rates tend to fall-stimulating spending and spurring economic activity.

While adequate for some purposes, this stylized description of the transmission mechanism is less helpful in explaining the complex relationship between interest rates and monetary policy that is actually observed in financial markets. In practice, the relationship between changes in the federal funds rate target and market interest rates appears to be looser and more variable than suggested by the stylized view, especially for longer-term interest rates. Moreover, sizable movements in market interest rates are often associated with economic data releases or statements by policymakers even when there is no accompanying change in the funds rate target. Indeed, many times market interest rates appear to anticipate rather than react to policy actions.

The stylized view of the transmission mechanism also provides little insight into the source of the Federal Reserve's leverage over market interest rates. Indeed, how does control over a relatively insignificant interest rate-the overnight federal funds rate-allow the Federal Reserve to influence the whole spectrum of short-term and long-term market rates?

This article describes a simple analytical framework that provides a better conceptual understanding of the monetary policy transmission mechanism and also helps explain the complex relationships between monetary policy and interest rates observed in financial markets. In this framework, financial market expectations about future monetary policy play a central role. Indeed, expectations about the path of future policy actions are the driving force in determining market interest rates. Consequently, understanding how financial markets construct this expected policy path and what factors cause the path to change is critical to understanding the transmission process and the behavior of interest rates.

The analysis also has broader implications for the design and implementation of monetary policy. In a world where policy expectations drive interest rates, what a central bank says about its long-run goals and about the economic outlook may be as important, or even more important, than what it does. Consequently, how a central bank communicates with the public and financial markets can play a crucial role in the transmission mechanism and the evolution of market interest rates.

The first section of the article provides a brief overview of the transmission mechanism, highlighting the complex relationships between the federal funds rate target and market interest rates. The second section sets out the framework for the analysis and examines the connection between the expected policy path and the term structure of interest rates. The third section discusses how changes in the policy path cause changes in the term structure. The fourth section illustrates how an estimate of the policy path can be derived from the Treasury yield curve and shows how new information about the economy and monetary policy influences the policy path and market interest rates. The fifth section shows how historical policy paths can be used to understand the linkage between monetary policy and long-term interest rates. The final section discusses some broader implications for monetary policy when expectations play a central role in the monetary policy transmission mechanism. …

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