FRBSF Economic Letter
97-18; June 13, 1997
Interest Rates and Monetary Policy
In the postwar period, the ultimate objectives of the Federal Reserve--namely
full employment and stable prices--have remained unchanged; however, the
Fed has modified its operational and intermediate objectives for monetary
policy several times in response to changes in the economic environment.
For example, in 1970, the Federal Reserve formally adopted monetary targets
in an attempt to use an intermediate nominal objective or anchor to resist
slowly rising inflation. Furthermore, from 1979 through the early 1980s,
a narrow monetary reserve aggregate was ostensibly used as the operational
instrument of policy. This period, however, was the high-water mark for
Over the past 15 years, the Federal Reserve and many other central banks
have increasingly relied on interest rates, to the almost complete exclusion
of monetary or reserve aggregates, both as sources of information for
determining policy and as operating instruments for conducting policy.
For example, when announcing its policy action on March 25, 1997, the
Federal Open Market Committee stated that it had "decided today to
tighten money market conditions slightly, expecting the federal funds
rate to rise 1/4 percentage point to around 5-1/2 percent." This
explicit characterization by the FOMC of a monetary policy action in terms
of a change in the overnight federal funds rate is just one signal of
the current preeminence of interest rates in the conduct of monetary policy.
This latest shift in the conduct of policy from money to interest rates
has been spurred by two developments: first, the breakdown of traditional
relationships between money and economic activity largely brought on by
innovations in payment and transactions technologies; second, the increasing
sophistication of financial markets and central banks regarding information
about the future as embedded in financial instruments (including, for
example, the emergence of derivatives and inflation-indexed debt).
One key aspect of interest rates that has become particularly important
for the operation of monetary policy is the term structure relationship
of short- and long-term rates. This Economic Letter reviews some
of the issues involved in answering two crucial questions for central
banks: (1) How should information in the term structure be interpreted
and used for conducting monetary policy? and (2) How will central bank
actions, especially those expressed as changes in a short-term interest
rate, affect the term structure of interest rates and, in turn, the rest
of the economy?
Interpreting the term structure
One way in which interest rates appear to be playing a larger role in
monetary policy is as informational indicators. For example, current expectations
about future inflation may help determine how the economy will perform
in later years. Therefore, central banks are interested in obtaining information
about current expectations from forward-looking financial markets in order
to help predict future paths for inflation and output.
In obtaining such information from financial markets, central banks
have relied on the "Expectations Theory" of the term structure.
This theory states that longer-term interest rates are set according to
market expectations of future shorter-term rates; specifically, rates
will be set so that a representative investor is indifferent between holding
a long-term bond or a sequence of short-term bonds covering the same length
of time. For example, as a first approximation, the current two-month
interest rate should equal the average of the current one-month rate and
the market's expectation of the one-month rate that will prevail one month
from now--the so-called one-month forward rate.
The short end of the term structure, say maturities of less than six
months, is one area of particular interest for central banks. At this
horizon, according to the expectations theory, interest rates primarily
reflect market expectations about very near-term monetary policy settings
of the overnight rate (as described in Rudebusch 1995a, b). Central banks
are interested in forward rates at this short horizon in part to understand
market expectations of the immediate path of the policy rate. Given such
expectations, central banks can evaluate whether their near-term policy
intentions are being appropriately communicated to markets. In the U.S.,
the market for federal funds futures, which has traded only since 1988,
provides particularly clear readings on forward policy rates over the
next few months (see Rudebusch 1996).
Besides obtaining near-term interest rate expectations,
central banks also are interested in the term structure at the five- to
ten-year horizon in order to get an indication of the market's inflation
expectations. According to common wisdom, the nominal yield on a
bond equals, to a first approximation, the real yield plus the average
expected inflation rate (the so-called Fisher equation). Assuming that
changes in real interest rates are known (or can be ignored), then changes
in nominal rates can be translated into changes in inflation expectations.
Central banks are keenly aware of the importance of such inflation expectations
both as inputs to forecasts of future inflation and economic activity
and as measures of the credibility of the central bank's current stance
of monetary policy in achieving the long-run goal of price stability.
Goodfriend (1993), for example, argues that inflation expectations obtained
from the term structure have had a major influence on the conduct of monetary
policy by the Federal Reserve.
Still, it should be stressed that interpreting the term structure is
not without some ambiguity, in part, because the application of the expectations
theory to obtain interest rate expectations from the term structure is
not always straightforward. For example, an investor considering the choice
between a long-term bond and a sequence of short-term bonds may demand
a premium in the latter case for facing the interest rate uncertainty
involved in the period-by-period rollover of debt. Thus, in general, the
two-month rate equals the average of the current and future one-month
rates plus a (possibly negative) term premium. An unobservable term premium
that varies over time certainly hinders the process of interpreting the
Although the evidence is not unambiguous (see, for example, Rudebusch
1995b and Campbell 1995), it appears that a time-varying term premium
is not too severe a problem for obtaining interest rate expectations at
short horizons--especially with high-frequency (say, daily) data--which
are often the focus of particular interest to central banks. However,
a time-varying term premium is more likely to be an important consideration
at the long maturities used to obtain inflation expectations. Furthermore,
movements in real interest rates at long horizons may be unclear, so that
the translation of nominal forward rates to inflation expectations may
be especially uncertain. There is, however, one recent development that
may help alleviate this second problem. The U.S. Treasury has started
to issue inflation-indexed debt, which should help pin down movements
in the real interest rate. Indeed, the Bank of England has used indexed
debt, which has been issued in Great Britain for over a decade, to obtain
estimates of real rates and inflation expectations. As described by Deacon
and Derry (1994), the Bank of England has found that the difference between
the nominal and real term structure provides a useful measure of inflation
Affecting the term structure
Besides interpreting the term structure of interest rates, central banks
also may be interested in altering it through shifts in monetary policy.
In the common textbook description of the transmission of monetary policy,
as encapsulated for example in the so-called IS-LM model, the supply of
money plays an important role. The equilibrium of money supply by the
central bank and money demand by the public (the LM curve) provides an
interest rate, which in turn helps to determine the demand for output
(via the IS curve). Currently, however, many central banks appear uninterested
in the quantity of money and instead focus directly on interest rates.
For example, the Federal Reserve Board's new large-scale macroeconomic
model of the U.S. economy that is designed to aid in understanding the
effects of monetary policy contains roughly 300 equations but includes
not a single money supply variable (see Brayton, et al. 1997).
Many central banks have simply taken a short-term interest rate as their
direct operating instrument. (For example, the popular Taylor (1993) Rule
description of Federal Reserve behavior assumes that the stance of monetary
policy is well represented by the federal funds rate.) In this case, the
monetary transmission mechanism operates from the short-term rate to real
spending on goods and services (that is, simply via the IS curve). Of
course, none of the important sectors of real spending--housing, investment,
or consumption--depends directly on the overnight federal funds rate.
Instead, spending depends on longer-term interest rates. In this way,
gauging how changes in the short rate induced by the central bank affect
the entire term structure of longer-term rates will be a crucial link
in understanding the monetary transmission mechanism.
Cook and Hahn (1989) provide some of the earliest information on the
effects of central bank actions on the term structure. They searched for
the days on which the Wall Street Journal reported that the Federal
Reserve had changed the federal funds rate. Then, for those days, they
correlated the actual changes in longer-term rates with the funds rate
changes. They found a substantial correlation that diminished, but never
disappeared, as the maturity of the longer-term security was increased.
For example, even the yield on a 10-year bond would typically rise 10
to 15 basis points on the day that the funds rate was increased by a percentage
point. In a sense then, the federal funds rate, as the instrument of Fed
policy, is the tip of the term structure tail that wags the dog of the
Of course, the movements in longer rates following a policy action are
not always the same. According to the expectations theory, these movements
reflect both the immediate change in the funds rate as well as market
expectations about future policy actions, which may vary with the exact
circumstances. For example, as described in Campbell (1995), the 10-year
rate jumped by almost twice as much as the increase in the funds rate
at the time of the Fed tightening in February 1994 instead of the typical
muted response described by Cook and Hahn. Such variability in financial
market responses is an important source of the uncertainty associated
with the real effects of monetary policy actions.
In the U.S. and other countries, interest rates are a key feature of
the conduct of monetary policy; therefore, central banks are concerned
about both how to interpret information from the term structure of interest
rates and how their actions affect the term structure. Research suggests
that, while short-term forward rates can give fairly accurate readings
of interest rate expectations in the short run, longer-term rates give
less clear readings of inflation expectations. As for monetary policy's
effects on the term structure, although research shows that longer-term
rates do tend to react when the fed funds rate moves, the size of this
response can vary substantially.
Brayton, Flint, Eileen Mauskopf, David Reifschneider, Peter Tinsley,
and John Williams. 1997. "The Role of Expectations in the FRB/US
Macroeconomic Model." Federal Reserve Bulletin 83 (April)
Campbell, John Y. 1995. "Some Lessons from the Yield Curve."
Journal of Economic Perspectives 9, no. 3, pp. 129-152.
Cook, Timothy, and Thomas Hahn. 1989. "The Effect of Changes in
the Federal Funds Rate Target on Market Interest Rates in the 1970s."
Journal of Monetary Economics 24, pp. 331-351.
Deacon, Mark, and Andrew Derry. 1994. "Estimating market interest
rate and inflation expectations from the prices of UK government bonds."
Bank of England Quarterly Bulletin (August) pp. 232-240.
Goodfriend, Marvin. 1993. "Interest Rate Policy and the Inflation
Scare Problem: 1979-1992." Federal Reserve Bank of Richmond Economic
Review 79, no.1, pp.1-24.
Rudebusch, Glenn D. 1995a. "Federal Reserve Policy and the Predictability
of Interest Rates." FRBSF Weekly Letter (June 23).
_______. 1995b. "Federal Reserve Interest Rate Targeting, Rational
Expectations, and the Term Structure." Journal of Monetary Economics
(April) pp. 245-274.
_______. 1996. "Do Measures of Monetary Policy in a VAR Make Sense?"
Federal Reserve Bank of San Francisco Working Paper 96-05.
Taylor, John. 1993. "Discretion vs. Policy rules in Practice"
Carnegie-Rochester Conference Series on Public Policy (February),
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