The decomposition of long-term interest rates and its contribution to monetary policy conduct

A nominal interest rate - the interest rate set when a loan is granted - includes a component that measures future interest rate expectations and a component referred to as term premium. For a central bank, this decomposition provides information on (i) economic actors' expectations of future interest rate changes, and thus the effects of monetary authorities' communications, and (ii) the compensation required by lenders for the risks they incur. This heavily depends on the uncertainty surrounding economic conditions and dynamics, and also the effects of monetary policy measures such as asset purchase programmes. Different types of risk therefore imply that some premiums are embedded in interest rates. Central banks take this decomposition into consideration when choosing their monetary policy stance. They have mathematical models to evaluate the decomposition, each one of which has its own advantages and disadvantages. This article presents a representative affine model, which notably takes into account an interest rate lower bound of less than zero. When applied to examples from the United States and the United Kingdom, this model highlights the effects of monetary policy measures on term premiums. By adapting this framework to a negative interest rate environment, interest rate swaps indexed on Eonia over the past ten years can be decomposed for the euro area.