FRBSF Economic Letter
2004-13; June 4, 2004
Interest Rates and Monetary Policy: Conference Summary
The six papers presented at this
conference address key questions, advancing our knowledge of how
macroeconomic shocks are transmitted
through the economy and how they affect the prices of financial
Four of the papers focus on the term structure of interest rates
(the relationship between short-term and long-term interest
rates) and how it interacts with macroeconomic fundamentals.
nominal interest rates may stem from any number of sources,
including movements in real interest rates, changes in expected
and changes in an asset's risk characteristics—default
risk, prepayment risk, and so on. The difficulty is that none
these sources can
be observed directly; instead, they must be inferred. Therefore,
several of the conference papers develop models that extract
information from the term structure of interest rates and macroeconomic
about these sources. Ang and Bekaert develop a model to extract
the real term structure, expected inflation, and inflation
risk, from nominal interest rates; Rudebusch and Wu formulate
macro-finance model and examine how the macroeconomic fundamentals
affect the term structure; Dai, Singleton, and Yang construct
a regime-switching model and relate different term structure
to the business cycle; and Piazzesi and Swanson extract risk
premiums from federal funds futures.
The remaining two papers
are more closely related to the monetary policy transmission
mechanism. Kozicki and Tinsley show how
imperfect policy credibility can affect the way macroeconomic
propagated through the economy; Onatski and Williams use
an estimated model to explore the design and robustness of policy
The term structure of real interest
Typically, the term structure of nominal interest rates has a
positive slope, that is, financial assets with longer maturities
tend to have higher interest rates than do assets with shorter
maturities. Ang and Bekaert explore this phenomenon by decomposing
movements in nominal interest rates into movements in real interest
rates and in expected inflation. Because real interest rates and
expected inflation cannot be directly observed, Ang and Bekaert
build a model that allows them to infer them from their impact
on other variables in the economy. They apply their model to data
on short-term rates (3-month nominal interest rates), longer-term
rates (four-, twelve-, and twenty-quarter maturity Treasury yields),
and a measure of inflation (the consumers price index). The authors
find that while short-term real interest rates are volatile and
long-term rates are smooth and persistent, there is no significant
slope to the real term structure. Instead, their results indicate
that the positive slope typically present in the nominal term structure
is caused by an inflation risk premium that is increasing in maturity.
Ang and Bekaert also find that variations in expected inflation
and in inflation risk premiums explain about 80% of the variation
in nominal interest rates and that these variables are also the
main determinants of nominal interest rate spreads at long horizons.
A macro-finance model of the term
Rudebusch and Wu develop a macro-finance model and examine the
joint movement of the term structure and macroeconomic variables.
The model provides macroeconomic interpretations of the unobservable
or "latent" factors found in empirical term structure
studies and also incorporates term structure dynamics into the
macroeconomic model following the tradition of the asset-pricing
approach from the finance literature.
By first closely examining
a canonical latent-factor term structure model, the authors find
that the "level" factor is closely
associated with the central bank's long-run inflation target and
that the "slope" factor captures the central bank's responses
to cyclical variations in inflation and output gaps. They then
incorporate such relationships in formulating the joint macro-finance
model. Model estimation indicates a close similarity between the
term structure factors from the macro-finance model and from the
canonical latent-factor model, suggesting that the macro-finance
model explains the dynamics of the latent factors in terms of macro
variables quite well.
The macro-finance model also facilitates incorporating
term structure information into the analysis of macroeconomic dynamics.
look into macroeconomic issues hotly debated among macroeconomists
and find that: (1) there is little term structure evidence suggesting "interest
rate smoothing" in the Federal Reserve's policy actions and
(2) while forward-looking elements are important determinants of
inflation dynamics, they are almost negligible determinants of
Regime shifts and changing risk
Dai, Singleton, and Yang establish a term structure model with
two regimes: in one regime, interest rate volatility is high, and
in the other, it is low. The authors also assume that the probabilities
of regime switches vary as the state of the economy changes over
time, and bond traders demand compensation for the risk inherent
in such regime switches. This model outperforms other regime-switching
term structure models in the literature in matching both the empirical
dynamics of expected bond returns and the relationship between
the shape of the term structure and business cycle fluctuations.
estimation reveals that the high-volatility regime tends to be
associated with economic downturns and on average is less
persistent than the low-volatility regime. This prediction is
consistent with the well-documented asymmetry in the U.S. business
that recoveries tend to last longer than contractions. Another
interesting implication of the model is that the risk premium
for a regime switch changes over business cycle. In particular,
investors are more willing to hedge against an economic downturn
than against an economic expansion. This implication is consistent
with the economic intuition that agents tend to have low marginal
rates of substitution of consumption during economic expansions
and high ones during recessions; therefore they are willing to
pay more to avoid a sharp income decline during recessions.
Futures prices and monetary policy
In recent years, federal funds futures rates have been widely
used as measures of financial markets' expectations of future monetary
policy. However, these measures can be distorted, because futures
rates reflect not only those expectations but also the uncertainty
surrounding them, as reflected in the risk premiums on the futures
contracts. In this paper Piazzesi and Swanson examine the properties
of such risk premiums and their implications for monetary policy.
examining data on federal funds futures rates from 1989 to 2003,
the authors conclude that the risk premiums on futures contracts
are positive on average and strongly countercyclical. Therefore,
using the futures rates as predictions of future federal funds
rates would tend to lead to overestimating the actual funds rates.
However, it turns out that nonfarm payroll employment growth
is able to predict the risk premiums reasonably well, implying
such biases could be reduced if the forecaster used nonfarm payroll
employment growth to predict the risk premiums and adjusted the
Permanent and transitory policy
Kozicki and Tinsley develop a model for monetary policy in which
the Federal Reserve is described as having an implicit inflation
target that evolves over time, changing in response to shocks.
Their model also assumes that this implicit inflation target is
known only to policymakers, and that everyone else has to form
an educated guess at its value. The model's structure allows both
the changing implicit inflation target and the perceived target
to be estimated and compared. Estimating their model over 1960-2001,
the authors find that the implicit inflation target is very sensitive
to supply shocks, as 75% of their impact on inflation passes permanently
into the target. The surge in inflation that occurred in the 1970s,
then, is described in terms of a rising implicit inflation target,
pushed higher and higher by successive oil price shocks.
same time, the perceived inflation target differs substantially
from the actual inflation target, especially when the actual
target is changing rapidly. These differences arise because people
a tough time distilling movements in the actual inflation target
from movements in observed inflation. In fact, the model estimates
suggest that learning only cuts the gap between the perceived
target and the actual target by 4% each quarter. Comparing the
of their model with those of a model with a fixed inflation target,
they show that time-variation associated with movements in the
perceived inflation target has contributed importantly to historical
fluctuations in inflation and long-term interest rates.
Policy performance of a macro
While much of the literature on monetary policy rules simply assumes
that central banks dislike variability in inflation and output
and uses this assumption as an ad hoc description of central bank
objectives, Onatski and Williams observe that an alternative approach
is to assume that policymakers try to maximize economic welfare.
In general, these two descriptions of the goals motivating monetary
policy need not produce similar policies. In fact, the authors
show that the economy behaves very differently depending on what
policymakers are trying to achieve when they formulate policy,
and, moreover, that the ad hoc description of how monetary policy
is formulated produces outcomes that are more in keeping with observed
policy behavior. Echoing other results in the literature, they
also show that simple rules, which depend on only a few macroeconomic
variables, perform nearly as well as rules that depend on many
variables, while being more robust to model uncertainty.
they use for constructing and evaluating monetary policy rules
is the dynamic New Keynesian model studied in Smets and Wouters
(2004). The model allows for price and wage rigidities and assumes
an environment in which firms face costs to installing new plant
and machinery. Because wages and prices are not fully flexible,
an appropriately designed monetary policy can usefully stabilize
economic fluctuations; an important question, then, is how to design
such a policy.
When estimating the model, the authors explore the
sensitivity of the estimation in Smets and Wouters (2004). The
Smets and Wouters took was to use methods that combine "prior" information
about model parameters with information about these parameters
contained in actual data. Onatski and Williams find that the model's
estimates, but not its qualitative implications, are sensitive
to the nature of this prior information.
Papers are available in pdf format at http://www.frbsf.org/economics/conferences/0403/index.html
Andrew, and Geert Bekaert. "The Term Structure of Real
Rates and Expected Inflation."
Dai, Qiang, Kenneth Singleton, and Wei Yang. "Regime
Shifts in a Dynamic Term Structure Model of U.S. Treasury Bond
Kozicki, Sharon, and Peter Tinsley. "Permanent
and Transitory Policy Shocks in an Empirical Macro Model with Asymmetric
Onatski, Alexei, and Noah Williams. "Empirical
and Policy Performance of a Forward-Looking Monetary Model."
Piazzesi, Monica, and Eric Swanson. "Futures
Prices as Risk-Adjusted Forecasts of Monetary Policy."
Rudebusch, Glenn, and Tao Wu. "A Macro-Finance
Model of the Term Structure, Monetary Policy, and the Economy."
Smets, Frank, and Raf Wouters. 2004. "An Estimated Stochastic
Dynamic General Equilibrium Model of the Euro Area." Journal
of the European Economic Association, forthcoming.