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Short rate expectations, term premiums, and central bank use of derivatives to reduce policy uncertainty

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  • P. A. Tinsley

Abstract

The term structure of interest rates is the primary transmission channel of monetary policy. Under the expectations hypothesis, anticipated settings of the short-term interest rate controlled by the central bank are the main determinants of nominal bond rates. Historical experience suggests that bond rates may remain relatively high even if the short-term interest rate is reduced to zero, in part due to term premiums reflecting uncertainty about future policy. Term spreads due to policy uncertainty may be reduced by central bank trading desk options that provide insurance against future deviations from an announced interest rate policy.

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Bibliographic Info

Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 1999-14.

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Date of creation: 1998
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Handle: RePEc:fip:fedgfe:1999-14

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Keywords: Interest rates ; Bonds;

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References

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  1. Brenner, Robin J. & Harjes, Richard H. & Kroner, Kenneth F., 1996. "Another Look at Models of the Short-Term Interest Rate," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 31(01), pages 85-107, March.
  2. Coenen, Günter & Orphanides, Athanasios & Wieland, Volker, 2003. "Price stability and monetary policy effectiveness when nominal interest rates are bounded at zero," Working Paper Series 0231, European Central Bank.
  3. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, vol. 53(2), pages 385-407, March.
  4. Miltersen, Kristian R & Sandmann, Klaus & Sondermann, Dieter, 1997. " Closed Form Solutions for Term Structure Derivatives with Log-Normal Interest Rates," Journal of Finance, American Finance Association, vol. 52(1), pages 409-30, March.
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  7. Laxton, Douglas & Prasad, Eswar, 2001. "Possible effects of European Monetary Union on Switzerland," Journal of Policy Modeling, Elsevier, vol. 23(5), pages 531-551, July.
  8. Sharon Kozicki & P.A. Tinsley, 1996. "Moving endpoints and the internal consistency of agents' ex ante forecasts," Finance and Economics Discussion Series 96-47, Board of Governors of the Federal Reserve System (U.S.).
  9. Ben S. Bernanke & Alan S. Blinder, 1989. "The federal funds rate and the channels of monetary transmission," Working Papers 89-10, Federal Reserve Bank of Philadelphia.
  10. Fedenia, Mark & Grammatikos, Theoharry, 1992. "Options Trading and the Bid-Ask Spread of the Underlying Stocks," The Journal of Business, University of Chicago Press, vol. 65(3), pages 335-51, July.
  11. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-87, September.
  12. Jeffrey Fuhrer & Brian Madigan, 1994. "Monetary policy when interest rates are bounded at zero," Working Papers 94-1, Federal Reserve Bank of Boston.
  13. Cecchetti, Stephen G, 1988. "The Case of the Negative Nominal Interest Rates: New Estimates of the Term Structure of Interest Rates during the Great Depression," Journal of Political Economy, University of Chicago Press, vol. 96(6), pages 1111-41, December.
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  15. Robert Tetlow & John C. Williams, 1998. "Implementing price stability bands, boundaries and inflation targeting," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
  16. Merton, Robert C., 1995. "Financial innovation and the management and regulation of financial institutions," Journal of Banking & Finance, Elsevier, vol. 19(3-4), pages 461-481, June.
  17. Sharon Kozicki & P.A. Tinsley, 1998. "Term structure views of monetary policy," Research Working Paper 98-07, Federal Reserve Bank of Kansas City.
  18. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
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Citations

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Cited by:
  1. Clouse James & Henderson Dale & Orphanides Athanasios & Small David H. & Tinsley P.A., 2003. "Monetary Policy When the Nominal Short-Term Interest Rate is Zero," The B.E. Journal of Macroeconomics, De Gruyter, vol. 3(1), pages 1-65, September.
  2. Sala, Luca & Söderström, Ulf & Trigari, Antonella, 2008. "Monetary Policy Under Uncertainty in an Estimated Model with Labour Market Frictions," CEPR Discussion Papers 6826, C.E.P.R. Discussion Papers.
  3. Sharon Kozicki & P.A. Tinsley, 2002. "Term premia : endogenous constraints on monetary policy," Research Working Paper RWP 02-07, Federal Reserve Bank of Kansas City.
  4. Melecky, Ales & Melecky, Martin, 2008. "From Inflation to Exchange Rate Targeting: Estimating the Stabilization Effects," MPRA Paper 10844, University Library of Munich, Germany.
  5. Paolo Savona & Aurelio Maccario & Chiara Oldani, 2000. "On Monetary Analysis of Derivatives," Open Economies Review, Springer, vol. 11(1), pages 149-175, August.
  6. Kozicki, Sharon & Tinsley, P. A., 2002. "Dynamic specifications in optimizing trend-deviation macro models," Journal of Economic Dynamics and Control, Elsevier, vol. 26(9-10), pages 1585-1611, August.
  7. Martina Cecioni & Giuseppe Ferrero & Alessandro Secchi, 2011. "Unconventional Monetary Policy in Theory and in Practice," Questioni di Economia e Finanza (Occasional Papers) 102, Bank of Italy, Economic Research and International Relations Area.
  8. Chiara Oldani, 2005. "An Overview of the Literature about Derivatives," Macroeconomics 0504004, EconWPA.
  9. Chiara Oldani, 2006. "money demand and futures," ISAE Working Papers 69, ISTAT - Italian National Institute of Statistics - (Rome, ITALY).

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