Expectations and the Monetary Policy Transmission Mechanism

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

Another method uses data on the Treasury yield curve to construct a policy path. This approach calculates expected future rates on Treasury securities to obtain an estimate of the policy path.15 As compared to using futures market data, the use of the Treasury yield curve allows an estimate of the policy path over a longer time horizon (beyond five years) and also is more useful for historical analysis.16

Three examples of historical policy paths derived from the Treasury yield curve are shown in Chart 9.17 These paths were chosen to illustrate situations in which markets expected the funds target to remain constant at its current level or expected policy to be tightened or eased. In each case, the path shows the current funds rate target and the expected target at horizons of six months and at one-year intervals out to seven years.18

As shown in the chart, in May 1963 the policy path was very flat. That is, financial markets expected the current 3 percent level of the funds rate to continue indefinitely." In contrast, in November 1992 and December 2000 financial markets expected the funds rate target to change over the next few years. In November 1992, the policy path was steeply upward-sloping; the current target of 3 percent was expected to rise to about 7 percent over the next three to four years. In contrast, in December 2000 financial markets expected the current funds rate target of 6.5 percent to be reduced to about 4.25 to 4.5 percent over a two- to three-year period.

These three examples of policy paths highlight some important features that appear to characterize policy paths more generally. First, the paths tend to be relatively flat beyond a horizon of three to four years, suggesting that financial markets expect the federal funds rate target to be unchanged over long time horizons. One interpretation of this feature is that markets have a view as to what an equilibrium or normal funds rate target should be, and when the current target is above or below the equilibrium level, it is expected to return to that level within a relatively short period of time. That is, when the Federal Reserve eases policy to offset economic weakness or tightens policy to head off inflationary pressures, the target changes are expected to be reversed within a few years.

A second general feature of policy paths illustrated in this chart is that financial markets' estimate of the equilibrium funds target appears to change over time.20 In May 1963, the markets' estimate of the equilibrium level was approximately 3 percent. By November 1992, the estimated equilibrium level had risen to around 7 percent. Then, in December 2000, the estimate of the equilibrium target had declined to about 4.25 to 4.5 percent.

A third general feature of policy paths illustrated in these examples is that the target is expected to return to its long-run equilibrium level relatively quickly. In both November 1992 and December 2000, the estimated policy paths suggest that markets thought the target would change about 100 basis points per year, with the total adjustment completed in less than four years.21