Monetary policy and U.S. long-term interest rates: How close are the linkages?

Abstract

The effect of monetary policy on long-term interest rates has been a question of interest in recent years. A number of papers, relying on single-equation estimation techniques, have presented evidence that long-term interest rates exhibit sizable and significant responses to unanticipated changes in the Federal Reserve's target federal funds rate. This paper examines these findings in light of conflicting findings from VAR studies, which indicate negligible effects of innovations in the federal funds rate on long-term rates. To address the issue we use a single-equation approach where unanticipated changes in the federal funds rate are measured as residuals from policy reaction functions. We also estimate VAR specifications, which incorporate information about the timing of changes in the Federal Reserve's target federal funds rate. Our single-equation estimates provide evidence of strong responses of long rates to unanticipated changes in the federal funds rate both for the Greenspan period and for a longer period back to the mid-1960s. It seems likely that estimated VARs for the post-1987 years are less successful in isolating monetary policy surprises than was the case for earlier years.

Can Monetary Policy Influence Long‐term Interest Rates? It Depends

“…These contrary findings in the literature were recently examined by Berument and Froyen (2009). They conclude that unanticipated changes in monetary policy can meaningfully influence long-term interest rates but note that this relationship is hard to find with VARs because innovations to the federal funds rates in these models may not fully isolate "surprises" in monetary policy.…”

“…On the other hand, a number of studies using VARs with weekly or monthly data find that structural shocks to the federal funds rates do not have a large effect on long‐term interest rates and sometimes this effect is statistically insignificant. Moreover, what little effect federal funds rate innovations do have on long‐term interest rates begins to disappear after 1979 (Berument and Froyen 2006; Berument and Froyen 2009; Edelberg and Marshall 1996; Evans and Marshall 1998; McMillin 2001). These two groups of studies, therefore, come to different conclusions on monetary policy's influence on long‐term interest rates.…”

“…The methods and findings from this empirical research can be grouped into two categories. On one hand there have been a number of studies using single‐equation models with daily data that find unanticipated changes in the federal funds rate can have a statistically significant and sizeable effect on long‐term interest rates (Beechey 2007; Berument and Froyen 2009; Cochrane and Piazzesi 2002; Ellingsten and Söderstrom 2003; Ellingsen, Söderstrom, and Masseng 2004; Gurkaynak, Sack, and Swanson 2005; Kuttner 2001; Poole et al 2002). On the other hand, a number of studies using VARs with weekly or monthly data find that structural shocks to the federal funds rates do not have a large effect on long‐term interest rates and sometimes this effect is statistically insignificant.…”

“…We do so by looking at monetary policy innovations to the monetary base in an estimated vector autoregression (VAR) to see how monetary policy shocks impact the entire term structure of U.S. Treasury interest rates 2 . Other studies that have used VARs to examine this relationship have relied on innovations to the federal funds rate as their measure of monetary policy shocks (Berument and Froyen 2006; Berument and Froyen 2009; Edelberg and Marshall 1996; Evans and Marshall 1998). This approach has become problematic as the federal funds rate has grown to be more predictable in recent times and thus less capable of generating monetary policy surprises in estimated VARs.…”

The Excess Smoothness and Sensitivity of Consumption in the V4 Countries

“…The excess sensitivity of consumption deals with anticipated changes of income and excess smoothness is due to unanticipated changes of income (Romer, 1996). In other words, consumption may be smoothed to current income, which has an unexpected part, and also sensitive to lagged income, which is known to the consumer (Campbell and Deaton, 1989;Pesaran, 2003;Ludvigson and Michaelides, 2001;Berument and Froyen, 2009;Bilgili, 2006;Blundell, Pistaferri and Preston, 2008;Attanasio and Pavoni, 2011).…”