Following up this post, some pushback on how important monetary policy was in providing the fuel for the financial crisis, but the “key point here is that there is evidence monetary policy still matters in a meaningful way for long-term interest rates”
The Monetary Policy – Long Term Interest Rate Link: Tyler Cowen argues that the Fed’s low interest rate policy in the early-to-mid 2000s may have been a contributing factor, but certainly was not the most important one leading to the financial crisis. In making his case, Tyler says the following:
[O]ther reasons also suggest that monetary policy was not the main driver. Money has a much bigger effect on short-term rates than long-term rates.
I am not sure what Tyler exactly means by “bigger”, but I do know there has been a spate of empirical studies showing monetary policy affects long-term rates in a non-trivial manner. Richard Froyen and Hakan Berument (F&B) provide a good survey of this literature in their forthcoming paper, “Monetary policy and U.S. long-term interest rates: How close are the linkages?” From their introduction is the following:
[T]he effect of monetary policy on long-term interest rates is a subject of considerable interest. Given current U.S. monetary policy procedures, this question reduces to that of how a change in the federal funds rate affects the yields on longer-term securities. A decade ago a reading of theliterature would have indicated considerable doubt about even the direction of this effect. There was also a view that the size and persistence of the effect of the federal funds rate on longerterm yields would vary with economic conditions. The prevailing theory of the term-structure of interest rates, the expectations hypothesis, by itself provides little guidance about the effect monetary policy actions will have on longer-term interest rates: the nature of the effect depends on the way in which the policy action affects expected future short-term interest rates and risk premiums imbedded in long rates.
Research since 2000 has changed the situation. Studies by Kuttner (2001), Cochrane and Piazzesi (2002), Gurkaynak, Sack, and Swanson (2005a), Ellingsen and Soderstrom (2003), Ellingsen, Soderstrom, and Masseng (2004) and Beechey (2007) provide evidence that unanticipated changes in the federal funds rate have significant effects on U.S. interest rates at maturities as long as 10 or 30 years. Kuttner’s estimates, for example, indicate that an unanticipated rise ofone-percentage point in the federal funds target rate will increase the interest rate on a 10-year government security by 32 basis points and the rate on a 30-year security by almost 20 basis points.
(F&B also note that though some research based on vector autoregressions (VAR) show results more consistent with Tyler’s view, these studies ultimately are flawed.) Now if we make the reasonable assumption that the drop of the fed funds rate (ffr) all the way to 1% for a sustained period was unexpected by several percentage points–the ffr has not been dropped that low since the 1950s–and adopt Kuttner’s magnitudes then it is easy to imagine the Fed having a significant influence on long term interest rates during the early-to-mid 2000s.
One could also argue that some of the “global saving glut” and its influence on long-term interest rates was simply an amplification of the Fed’s easy monetary policy via the dollar block countries’ central banks. But I digress. The key point here is that there is evidence monetary policy still matters in a meaningful way for long-term interest rates.
Originally published at Economist’s View and on Oct 22, 2008 reproduced here with the author’s permission.