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Longer-term perspectives on the yield curve and monetary policy

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  • Sharon Kozicki
  • Gordon Sellon

Abstract

In the spring of 2004, there was widespread expectation in financial markets that the Federal Reserve would shortly begin the process of raising its federal funds rate target back toward a more normal level. At the time, there was considerable concern that removing policy accommodation could lead to a sharp rise in long-term interest rates that might roil financial markets or slow the economic recovery. Much of this concern was based on the sizable increases in long-term rates that occurred when the Federal Reserve tightened policy in 1994-95 and 1999-2000. In contrast to the conventional wisdom, however, longer-term rates actually declined as the funds rate target rose. Indeed, in August 2005, after the Federal Reserve had raised its federal funds rate target from 1 percent to 3½ percent, the yield on the benchmark 10-year Treasury note remained below its level at the onset of policy tightening. This surprising behavior of long-term rates has been labeled a “conundrum” by Federal Reserve Chairman Greenspan and many financial market participants, and considerable effort has been made to understand the causes of the conundrum and its implications for monetary policy. Kozicki and Sellon provide a framework for understanding the relationship between monetary policy and the yield curve that can be used to analyze the behavior of long-term rates during periods of monetary policy tightening. The authors use the framework to examine two recent episodes of policy tightening, in 1999-2000 and 2004-05. The analysis reveals that the conundrum period is highly unusual, but it also suggests that the relationship between monetary policy and the yield curve is quite complex and highly variable over time.

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Bibliographic Info

Article provided by Federal Reserve Bank of Kansas City in its journal Economic Review.

Volume (Year): (2005)
Issue (Month): Q IV ()
Pages: 5-33

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Handle: RePEc:fip:fedker:y:2005:i:qiv:p:5-33:n:v.90.no.4

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Keywords: Monetary policy ; Interest rates ; Federal funds rate;

References

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  1. Tao Wu & Glenn Rudebusch, 2005. "The Recent Shift in Term Structure Behavior from a No-Arbitrage Macro-Finance Perspective," Computing in Economics and Finance 2005 3, Society for Computational Economics.
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Cited by:
  1. Goda, Thomas & Lysandrou, Photis & Stewart, Chris, 2013. "The contribution of US bond demand to the US bond yield conundrum of 2004–2007: An empirical investigation," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 27(C), pages 113-136.
  2. Modena, Matteo, 2008. "The term structure and the expectations hypothesis: a threshold model," MPRA Paper 9611, University Library of Munich, Germany.
  3. Moura, Marcelo L. & Gaião, Rafael Ladeira, 2012. "Impact of macroeconomic surprises on the brazilian yield curve and expected inflation," Insper Working Papers wpe_288, Insper Working Paper, Insper Instituto de Ensino e Pesquisa.
  4. ARANHA, Marcel Z. & MOURA, Marcelo L., 2008. "The impact of monetary policy on the yield curve in the Brazilian economy," Insper Working Papers wpe_157, Insper Working Paper, Insper Instituto de Ensino e Pesquisa.
  5. Bandholz, Harm & Clostermann, Jörg & Seitz, Franz, 2007. "Explaining the US bond yield conundrum," OTH im Dialog: Weidener Diskussionspapiere 2, University of Applied Sciences Amberg-Weiden (OTH).
  6. Moura, Marcelo L. & Gaião, Rafael L., 2014. "Impact of macroeconomic surprises on the Brazilian yield curve and expected inflation," The North American Journal of Economics and Finance, Elsevier, vol. 27(C), pages 114-144.
  7. Modena, Matteo, 2008. "Yield curve, time varying term premia, and business cycle fluctuations," MPRA Paper 8873, University Library of Munich, Germany.

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