Monetary Policy and the Behavior of Long-Term Real Interest Rates

By Fuhrer, Jeffrey C. | New England Economic Review, September-October 1995 | Go to article overview

Monetary Policy and the Behavior of Long-Term Real Interest Rates


Fuhrer, Jeffrey C., New England Economic Review


A time-honored description of the "monetary transmission channel" - the set of linkages that run from the instrument that the Federal Reserve controls to its ultimate goals, low unemployment and low, stable inflation - suggests that the Fed controls the federal funds rate, which affects the rates on longer-term credit market instruments, which affect the expected real (inflation-adjusted) rates on longer-term instruments, which affect real spending on interest-sensitive goods, which affects unemployment and inflation.(1) This description is used quite widely in commentary on the state of the economy and the appropriate stance of monetary policy. And yet one key link in the chain, the expected real long-term interest rate, is not observable. There is no market in the United States in which participants trade long-term debt contracts that are negotiated in real terms (adjusted for the inflation rates that are expected to prevail over the life of the contracts), and thus we do not directly observe expected long-term real interest rates.(2) One can search all of the available economic data and never find a series with such a description.

This poses an interesting problem for macroeconomic modelers and policymakers. While a vast array of nominal yields on financial instruments are available, these yields convey only part of the information necessary to flesh out the conventional transmission channel.(3) Moreover, Bernanke and Blinder (1992) have observed that the federal funds rate, a short-term nominal interest rate, has been very well correlated over the past 30 years with subsequent movements in real activity. Does this empirical observation imply that we can ignore the difficulties inherent in linking short-term nominal rates to expected long-term real rates and posit a simpler "Bernanke-Blinder" transmission channel in which nominal rates directly affect real economic activity? This would be somewhat disconcerting, because most of our theories predict a relationship between longer-term real rates and real activity.(4) Or does the correlation between nominal short rates and real output proxy for a more understandable correlation between long real rates and real activity?

This article explores the link between the behavior of monetary policy and inferences about the behavior of the expected long-term real rate of interest. Analysis of this link reveals a reasonable empirical basis for the standard transmission channel, and an explanation of the Bernanke-Blinder observation that is fully consistent with the standard transmission channel.

I. A Simple Framework for Understanding the Link from Monetary Policy to Long-Term Interest Rates(5)

If the description of the transmission channel in the first paragraph of this article is approximately correct, then the behavior of long-term real interest rates will depend importantly on the current and expected behavior of the federal funds rate, and thus on the behavior of the FOMC, the body that sets the funds rate.

Monetary Policy

The starting point for the framework is the description of the behavior of monetary policymakers. Their ultimate goals are a stable and low inflation rate, [[Pi].sub.t], and a level of real activity, [y.sub.t], that is stable around its "potential." To achieve these goals, the Fed changes the federal funds rate, [rff.sub.t], so as to "lean against the wind," raising the funds rate when inflation is above its target, and lowering it when output falls below its potential. It may choose to respond more vigorously to deviations of inflation from its target, or to deviations of output around potential, or equally to both. The vigor with which the Fed responds to deviations of its ultimate concerns from their targets is summarized in the "reaction function" coefficients [[Alpha].sub.[Pi]] and [[Alpha].sub.y] in equation (1).(6)

[Mathematical Expression Omitted]

Equation (1) will be the complete description of monetary policy for the purposes of this article. …

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