Expectations and the Monetary Policy Transmission Mechanism

Federal Reserve Bank of Kansas City - Economic Review, Fourth Quarter 2004 by Sellon, Gordon H Jr

"For successful monetary policy is not so much a matter of effective control of overnight interest rates as it is of shaping market expectations of the way in which interest rates, inflation, and income are likely to evolve over the coming year and later. "

-Michael Woodford

In principle, the monetary policy transmission mechanism can be described rather simply. When the Federal Reserve raises its target for the federal funds rate, other interest rates also rise-reducing interest-sensitive spending and slowing the economy. Conversely, when the federal funds rate target is lowered, other interest rates tend to fall-stimulating spending and spurring economic activity.

While adequate for some purposes, this stylized description of the transmission mechanism is less helpful in explaining the complex relationship between interest rates and monetary policy that is actually observed in financial markets. In practice, the relationship between changes in the federal funds rate target and market interest rates appears to be looser and more variable than suggested by the stylized view, especially for longer-term interest rates. Moreover, sizable movements in market interest rates are often associated with economic data releases or statements by policymakers even when there is no accompanying change in the funds rate target. Indeed, many times market interest rates appear to anticipate rather than react to policy actions.

The stylized view of the transmission mechanism also provides little insight into the source of the Federal Reserve's leverage over market interest rates. Indeed, how does control over a relatively insignificant interest rate-the overnight federal funds rate-allow the Federal Reserve to influence the whole spectrum of short-term and long-term market rates?

This article describes a simple analytical framework that provides a better conceptual understanding of the monetary policy transmission mechanism and also helps explain the complex relationships between monetary policy and interest rates observed in financial markets. In this framework, financial market expectations about future monetary policy play a central role. Indeed, expectations about the path of future policy actions are the driving force in determining market interest rates. Consequently, understanding how financial markets construct this expected policy path and what factors cause the path to change is critical to understanding the transmission process and the behavior of interest rates.

The analysis also has broader implications for the design and implementation of monetary policy. In a world where policy expectations drive interest rates, what a central bank says about its long-run goals and about the economic outlook may be as important, or even more important, than what it does. Consequently, how a central bank communicates with the public and financial markets can play a crucial role in the transmission mechanism and the evolution of market interest rates.

The first section of the article provides a brief overview of the transmission mechanism, highlighting the complex relationships between the federal funds rate target and market interest rates. The second section sets out the framework for the analysis and examines the connection between the expected policy path and the term structure of interest rates. The third section discusses how changes in the policy path cause changes in the term structure. The fourth section illustrates how an estimate of the policy path can be derived from the Treasury yield curve and shows how new information about the economy and monetary policy influences the policy path and market interest rates. The fifth section shows how historical policy paths can be used to understand the linkage between monetary policy and long-term interest rates. The final section discusses some broader implications for monetary policy when expectations play a central role in the monetary policy transmission mechanism.

I. AN OVERVIEW OF THE POLICY TRANSMISSION MECHANISM

Like many central banks, the Federal Reserve implements monetary policy by setting a target level for a short-term market interest rate. Eight times a year, the Federal Open Market Committee (FOMC) meets to review the outlook for the economy and establishes a target for the overnight federal funds rate that is believed to be consistent with its longer-run objectives for price-stability and economic performance. Once a target level is set, it remains at that level until the FOMC believes it should be changed.1 For example, signs of inflationary pressures might cause the FOMC to raise the target, while signs of economic weakness might lead to a lower target. Since the federal funds rate itself is a market rate and not set by the Federal Reserve, the Federal Reserve uses open market operations to adjust the supply of reserves in the banking system to keep the federal funds rate close to the target level.

Important features of the federal funds rate target and the relationship between the federal funds rate and the target are shown in Charts 1 and 2. On a daily basis, differences in the two series can be large (Chart 1). The target series is very smooth; the target typically changes in small steps of 25 to 50 basis points in one direction for an extended period of time. Over the period examined, the target has varied from a high of 8.25 percent in early 1990 to a low of 1 percent in 2003-04. In contrast, the federal funds rate can change by several hundred basis points from one day to the next. Despite the daily volatility, though, the trend in the funds rate tends to follow the target series quite closely. Moreover, as shown in Chart 2, over the longer period of a month, the two series are almost identical, suggesting that the Federal Reserve can achieve close control of the funds rate over a relatively short horizon.2