Expectations and the Monetary Policy Transmission Mechanism

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

Following this logic, market rates on longer-term securities can also be expressed as an average of the current funds rate target and the series of expected targets over the life of the security.4 In the remainder of this article, the term "policy path" denotes this sequence of current and expected future funds rate targets.

The policy path and the term structure of interest rates

To understand the close relationship between the policy path and market interest rates implied by the expectations theory, it may be helpful to see what happens to market rates when the Federal Reserve follows a simple policy path. Chart 4 shows a situation where the funds rate target is 3 percent in the initial month (January), and financial markets expect the target to rise 25 basis points every three months (April, July, October, January) until it reaches 4 percent in a year. Once it reaches 4 percent, the target is expected to remain there indefinitely. This sequence of targets is the policy path expected by financial markets as of January. Chart 4 shows how the three-month, six-month, one-year, five-year, and ten-year rates will change over time as the funds rate target is raised over the next 12 months, assuming the Federal Reserve follows the expected policy path.5

This chart illustrates three important features of the relationship between the policy path and interest rates. First, interest rates at all maturities rise through time when markets expect the funds rate target to rise. The increase in rates is a direct result of the averaging process implied by the expectations theory. As time goes by, lower target rates drop out of the average and are replaced by higher target rates.

second, interest rates tend to rise in anticipation of the expected changes in the target rate and exhibit little response on the day the target is actually changed. This behavior is a direct result of the assumption that the Federal Reserve adjusts the funds rate target exactly as markets expect. If instead, the Federal Reserve deviates from the expected path, market rates would likely react strongly to the unexpected target change, as discussed in more detail in the next section of the article.

Third, over the year in which the target rises, short-term rates increase by a much larger amount than longer-term rates. For example, the three-month rate rises the full 100-basis-point increase of the target rate, while the five-year rate increases only 12.5 basis points, and the ten-year rate only 6.25 basis points. This difference reflects the fact that the full extent of policy tightening is already built into longer-term rates even before the tightening begins, while the full extent of tightening is only reflected in short-term rates over time.6

Another useful way of looking at the relationship between the policy path and interest rates is to see how the path is related to the yield curve or term structure of interest rates. Chart 5 shows yield curves derived from the example in Chart 4 for the initial month of January and for each month the target rate is increased (April, July, October, and January). Each yield curve is simply the cross-section of interest rates at each date and can be constructed by looking at the vertical distance between rates for each date in Chart 4. For the initial month of January, the yield curve is steeply upward-sloping with shortterm rates well below longer-term rates, reflecting the anticipated policy tightening. Over time, the yield curve becomes flatter as the expected changes in the target rate actually occur. Once the target rate reaches 4 percent in a year's time, the yield curve becomes horizontal, reflecting the assumed constancy of the target rate beyond one year.