Are Fiscal and Monetary Policies reflected in Real Yields? Evidence from a period of Disinflation and Declining Deficit Targets

We examine the effect of monetary and fiscal policies on yields on short- and long-term indexed bonds, in view of the crucial importance of these yields for economic activity. We extend the current literature dealing with the same question by providing evidence about a period in which the government adopted declining inflation and fiscal targets. In such cases the policy shift could be perceived as having implications in the long run and therefore may effect long-term as well as short–term yields. The fact that most government bonds in Israel are CPI-indexed allows us to use the real yields for the various terms directly, without having to decompose nominal yields into a real component and inflation expectations, as is the case with the data for other countries. Our main finding is that fiscal and monetary policies do affect short– and long-term yields. We find that a rise of one percent in the expected deficit/GDP ratio (cyclically adjusted) increases the long-term interest rate by 0.2 percentage points, i.e., Ricardian equivalence does not obtain fully. Another finding is that fiscal policy has a slightly greater effect on long-term yields than on medium- and short-term yields. In addition, changes in the government’s deficit targets affect long–term yields. With regard to the effect of monetary policy, the longer the term of bonds, the weaker is the effect on yields, although the effect on long-term yields is by no means inconsiderable. A one-percentage-point rise in the central bank’s key interest rate (in real terms) serves to increase the yield on one-year bonds by 0.8 percentage points, and the yield on 10-year bonds by 0.3 percentage points. Part of the significant long-term influence of monetary policy stems from its direct effect on the long-term component of yields—which we isolate in this study (the forward component). Our results are best interpreted as evidence for a long-term effect of monetary policy during a (credible) disinflation process. We also find that in the wake of financial liberalization and the greater openness of the economy, the US interest rate has come to affect the yields on domestic bonds, albeit less significantly than expected in a fully open economy.