Monetary Policy Tightening and Long-Term Interest Rates
Amaral, Pedro, Economic Commentary (Cleveland)
The Federal Open Market Committee (FOMC) has maintained an accommodative monetary policy ever since the 2007 recession, and some financial market participants are concerned that long-term interest rates may increase more than should be expected when the Committee starts to tighten. But a look at five historical episodes of monetary policy tightening suggests that such an outcome is more likely when markets are surprised by policy actions or economic developments. Given the Fed's new policy tools, especially its evolution toward more transparent communications, the odds of a surprise are far less likely now.
In the wake of the last recession, the Federal Open Market Committee (FOMC) implemented what has arguably been the longest and most accommodating spell of monetary policy in its history. The Committee's traditional monetary policy tool, the federal funds rate (FFR), has been as low as it can be-at the zero lower bound, in economics jargon- since late 2008.
During the same time, new tools designed to deliver further accommodation in the context of the zero lower bound have been introduced. For example, in an effort to lower long-term interest rates, the Fed has purchased a substantial amount of assets that historically it has not held much of, like long-term Treasury securities and the debt and mortgage-backed securities (MBS) of federal agencies like Fannie Mae.
Another type of tool involves the Committee's communications with the public. In the statements it puts out after each meeting, the Committee has been using language meant to provide the market with "forward guidance"-information about what policy will likely be in the future. Recently, the Committee has promised to keep rates low for an extended period of time and conditioned the future path of the federal funds rate and the Fed's balance sheet on particular economic outcomes.
Perhaps because of the unprecedented nature of this episode, some financial market participants have raised concerns regarding the possibility that long-term interest rates may increase more than should be expected when the Committee starts to tighten. (As if on cue, in late June, the 10-year Treasury rate moved up almost 50 basis points in the space of two weeks.)
But I think history-and the Fed's new policy tools- suggest otherwise. After studying past tightening episodes, I conclude that the move to a less accommodative monetary policy stance is unlikely to bring about significant disruptions to credit markets, unless both the markets and the FOMC seriously underestimate future growth (or equivalently, future inflation). While some of the current circumstances, like the relatively high maturity of Treasuries outstanding or the historically unprecedented size of the Federal Reserve's balance sheet, may pose challenges, these should be overcome by the current set of policy tools the FOMC has at its disposal.
Tightening Cycles since 1983
I look back at each of the preceding five tightening episodes since 1983 to examine how long-term interest rates behaved. I started the analysis in 1983 because it coincides with a period of significant change in Fed policy Paul Volcker had just finished his first term as chairman of the Federal Reserve (he would be reappointed by President Reagan in July 1983). Volcker is widely credited with having ended years of stagflation-high unemployment and high inflation-during his first term and having inaugurated a new era of FOMC monetary policy in terms of its efficacy and credibility.
The Fed's monetary policy goals, as mandated by Congress in its 1977 amendment to the Federal Reserve Act, are twofold: price stability and maximum employment. Although the FOMC has considerable discretion in the pursuit of those goals, traditionally, monetary policy has been conducted by targeting the federal funds rate-the overnight interest rate at which depository institutions trade balances held at the Federal Reserve. Although the Committee does not set the fed funds rate directly, it conducts open market operations (trading short-term government securities with depository institutions) to keep the rate close to the Committee's target. …