Tuesday, October 21, 2008

The Monetary Policy - Long Term Interest Rate Link

Tyler Cowen argues that the Fed's low interest rate policy in the early-to-mid 2000s may have been a contributing factor, but certainly was not the most important one leading to the financial crisis. In making his case, Tyler says the following:
[O]ther reasons also suggest that monetary policy was not the main driver. Money has a much bigger effect on short-term rates than long-term rates.
I am not sure what Tyler exactly means by "bigger", but I do know there has been a spate of empirical studies showing monetary policy affects long-term rates in a non-trivial manner. Richard Froyen and Hakan Berument (F&B) provide a good survey of this literature in their forthcoming paper, "Monetary policy and U.S. long-term interest rates: How close are the linkages?" From their introduction is the following:
[T]he effect of monetary policy on long-term interest rates is a subject of considerable interest. Given current U.S. monetary policy procedures, this question reduces to that of how a change in the federal funds rate affects the yields on longer-term securities. A decade ago a reading of theliterature would have indicated considerable doubt about even the direction of this effect. There was also a view that the size and persistence of the effect of the federal funds rate on longerterm yields would vary with economic conditions. The prevailing theory of the term-structure of interest rates, the expectations hypothesis, by itself provides little guidance about the effect monetary policy actions will have on longer-term interest rates: the nature of the effect depends on the way in which the policy action affects expected future short-term interest rates and risk premiums imbedded in long rates.

Research since 2000 has changed the situation. Studies by Kuttner (2001), Cochrane and Piazzesi (2002), Gurkaynak, Sack, and Swanson (2005a), Ellingsen and Soderstrom (2003), Ellingsen, Soderstrom, and Masseng (2004) and Beechey (2007) provide evidence that unanticipated changes in the federal funds rate have significant effects on U.S. interest rates at maturities as long as 10 or 30 years. Kuttner’s estimates, for example, indicate that an unanticipated rise ofone-percentage point in the federal funds target rate will increase the interest rate on a 10-year government security by 32 basis points and the rate on a 30-year security by almost 20 basis points.
(F&B also note that though some research based on vector autoregressions (VAR) show results more consistent with Tyler's view, these studies ultimately are flawed.) Now if we make the reasonable assumption that the drop of the fed funds rate (ffr) all the way to 1% for a sustained period was unexpected by several percentage points--the ffr has not been dropped that low since the 1950s--and adopt Kuttner's magnitudes then it is easy to imagine the Fed having a significant influence on long term interest rates during the early-to-mid 2000s.

One could also argue that some of the "global saving glut" and its influence on long-term interest rates was simply an amplification of the Fed's easy monetary policy via the dollar block countries' central banks. But I digress. The key point here is that there is evidence monetary policy still matters in a meaningful way for long-term interest rates.


  1. Any thoughts about that famous "conundrum" of the 2005 era when the Fed raised short term rates while long-term rates refused to budge? Presumably one factor - as suggested by Cochrane - is falling term premia as a result of Great Moderation.

  2. ECB:

    I remember Fed officials a few years back making the claim the conundrum was most likely the result of falling term premia. They dismissed the other obvious interpretation: the yield curve was becoming inverted and pointing to a recession. One reason for dismissing this possibility is that long-term rates were falling around the world, not just in the United States. Now that we have (1) a recession and (2) it appears to be global in scope, maybe there was no conundrum after all: yield curve spreads across the globe were predicting a global recession.

    I am now going to have to go back and look at that 2006 Bernanke speech where he discusses the conundrum vs. recession interpretation of the yield curve. It could make for an interesting post.

  3. Perhaps I am being too hard on Tyler, but some of his recent commentary has been puzzling. This claim has been the source of a great deal of research (as discussed in the paper you linked).

    Further, Milton Friedman emphasized in his article "The Lag in Effect of Monetary Policy" that we needn't be solely concerned with interest rates, but rather with the effect of monetary change on the flow of income. Thus even if we accept Cowen's claim at face value, it doesn't seem to prove what he thinks it does.

  4. Not many people think about long term interest rates nowadays. Especially now, with the economic crisis, immediate solutions are looked for.