TAILIEUCHUNG - Using the TermStructure of Interest Rates for Monetary Policy

Clearly, interest rate policy implemented by the Fed’s current operating procedures could not survive in this case. If the Fed persisted in implementing interest rate policy with its current procedures, the Fed would continually sell securities to withdraw reserves and currency. Reserves, for example, would be withdrawn to keep their marginal narrow liquidity services yield from falling below the interest opportunity cost represented by the federal funds rate target. If the transaction demand for reserves disappeared completely, the Fed would end up withdrawing all bank reserves in defense of its federal funds rate target and lose its power to influence. | Using the Term Structure of Interest Rates for Monetary Policy Marvin Goodfriend The term structure of interest rates . the yield curve has long been of interest to monetary policymakers and their advisers. The transmission of monetary policy is conventionally viewed as running from shortterm interest rates managed by central banks to longer-term rates that influence aggregate demand. A central bank s leverage over longer-term rates comes from the fact that the market determines these as the average expected level of short rates over the relevant horizon abstracting from a term premium and default risk . Working in the other direction the long bond rate contains a premium for expected inflation and thus serves as an indicator of the credibility of a central bank s commitment to low inflation. 1 Different theoretical perspectives support the two above-mentioned uses of the term structure for monetary policy John Hicks s 1939 expectations theory of the term structure supports the first and Irving Fisher s 1896 decomposition of nominal bond rates into expected inflation and an expected real return supports the The two views are compatible in principle although reconciling them creates difficulties of interpretation in practice. For example does a steepening yield curve indicate a loss of confidence in the central bank s commitment to low inflation or does it indicate that markets expect tighter The author is Senior Vice President and Director of Research. This article is an edited version of a paper written for the book Money and Interest Rates I. Angeloni and R. Rovelli eds. Macmillan 1998 proceedings of a conference sponsored by Banca d Italia and IGIER University Bocconi. Macmillan holds the copyright. The comments of Mike Dotsey Bob Hetzel Andy Olmem John Walter and participants at the Bank of England workshop on Extracting Information from Financial Markets are greatly appreciated. The views are the author s and not necessarily those of the Federal .

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