Expectations and the Monetary Policy Transmission Mechanism

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

Timing of policy path changes

The second factor influencing the response of market rates to changes in the policy path is the market's estimate of when the expected change in the policy path is likely to occur. Generally speaking, the further in the future a change in the path is expected, the smaller the response of short-term rates relative to longer-term rates.

The influence of timing is illustrated in Chart 7. Initially the yield curve is flat, incorporating market expectations that the funds target will remain at its current level of 4 percent. Then, the markets receive new information suggesting that the target is likely to increase to 5 percent in six months time. Very short-term rates-three-month and six-month rates-do not respond at all to the revision in the policy path because it occurs beyond their maturity. The one-year rate rises immediately by 50 basis points, reflecting the fact that the 5 percent target will be effective for half of its maturity. What happens to rates beyond a year depends on how persistent the change in the policy path is expected to be, as in Chart 6. Even a change in the policy path expected to last ten years causes a steepening of the yield curve rather than a parallel shift because short-term rates do not initially respond to the shift in the policy path. Thus, the main message of Chart 7 is that short-term rates may respond less than longer-term rates to a change in the policy path to the extent that the change is expected to occur in the more distant future. If so, the slope of the yield curve may change well in advance of a change in the target rate.

Size of policy path changes

A third factor influencing the response of market rates to changes in the policy path is the size of the change in the policy path. The examples considered so far focus on single, relatively small changes in the expected target rate. As shown in Chart 1, however, a tightening or easing cycle typically involves multiple, small target changes than can cumulate into a large total change. For example, both easing cycles in 1990-93 and 2001-04 involved a reduction in the funds rate target of over 500 basis points, while the tightening cycle in 1994-95 involved an increase of 300 basis points. Thus, it is important to consider what might happen to market rates if market participants build a series of target changes into a revised policy path.

Generally speaking, a small initial change in the funds rate target can be associated with large changes in market rates, even long-term rates, when the initial target change leads markets to believe that additional changes will be forthcoming. This point is illustrated in Chart 8. Similar to the two previous examples, the target is initially expected to remain constant at 4 percent, and the yield curve is flat. Now, consider two alternative scenarios. In the first scenario, there is an immediate 100-basis-point increase in the funds rate target from 4 to 5 percent, which markets expect to last two years. As shown in the chart, the yield curve shifts up 100 basis points out to a maturity of two years, while the five-year and ten-year rates rise 40 and 20 basis points, respectively. In the second scenario, markets are assumed to build an additional 100-basis-point increase into the target in six months time and another 100-basis-point increase in a year, for a total increase of 300 basis points.9 In this scenario, the yield curve shifts up by a much larger amount. Indeed, the one-year and two-year rates rise more than the amount of the initial target increase, the five-year rate rises almost 100 basis points, and the ten-year rate rises 45 basis points.