Expectations and the Monetary Policy Transmission Mechanism

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

This article focuses on the next step in the transmission process-how control over the federal funds rate allows the Federal Reserve to influence the whole structure of market interest rates. Since households and businesses generally borrow for much longer terms than overnight, how does control over an overnight rate allow the Federal Reserve to affect longer-term borrowing costs?

A good starting point for seeing how changes in the funds rate target are transmitted to longer-term rates is to look at historical relationships between the funds rate target and longer-term interest rates. Chart 3 shows the relationship since 1990 between the funds rate target, the one-year Treasury rate, and the ten-year Treasury rate. Both the one-year and ten-year rates play an important role in the economy. For example, many adjustable-rate mortgages are tied to the one-year rate, while rates on 30-year, fixed-rate mortgages tend to move with the ten-year rate.

Although the three series generally move up and down together, as shown in the chart, the relationship between the funds rate target and ten-year rate is clearly much looser than the relationship between the target and the one-year rate. In particular, the ten-year rate appears to respond much less to decreases in the funds rate target than to increases. Moreover, the ten-year rate appears to move considerably in advance of changes in the target, a particularly notable feature from 1999 to 2000. From this chart, it would appear that the Federal Reserve has much less leverage over longer-term rates than short-term rates.

To understand these differences and explore the connection between monetary policy actions and market interest rates in more detail requires a model describing these relationships. The next section presents a simple framework showing how market interest rates depend, not only on today's federal funds rate target, but also on expected future targets. The following section describes how changes in current and future targets affect the entire term structure of interest rates.

II. POLICY EXPECTATIONS AND THE TERM STRUCTURE

The model of interest rates most widely used by economists and financial market practitioners is the expectations theory of the term structure. According to the expectations theory, the interest rate on any security can be viewed as an average of today's federal funds rate target and the entire series of future targets expected by financial markets over the life of the security. Knowledge of this path of expected future targets provides important insight into the term structure of interest rates and its evolution over time.

The "policy path"

As shown in Chart 2, the Federal Reserve controls the federal funds rate very closely over a month. Consequently, the one-month rate in equation (2) should be closely tied to the current funds rate target, and the expected one-month rates over the next 11 months should be closely tied to the expected level of the target in each month over the remainder of the year. In this way, the one-year rate can be expressed as a simple average of the current target and the expected target over the balance of the year. Then, by equation (1), the two-year rate also can be expressed as an average of the current funds rate target and the expected target over the next two years.