Monetary Policy Effectiveness and Yield Curve Dynamics

The question of how monetary policy translates across the yield curve is at the forefront of many recent policy debates. This debate takes on added intensity when the choice of policy regime is heterogeneous. Monetary policy targets the very short end of the yield curve, although real economic activity is largely influenced by medium- to long-term market interest rates. Given efficient market conditions, conventional wisdom asserts that changes to the monetary policy instrument (policy interest rate) lead to an immediate change in market interest rates and bond prices distributed over all maturities; yet evidence supporting this view remains elusive. Using the expectations hypothesis as a benchmark, an empirical analysis of daily yield rates for the Japanese money and government bond markets for the period 2000 to 2009 provides evidence for segmentation over the yield curve. The expectations hypothesis receives little support in either an interest rate targeting or quantitative targeting regime, but the policy impact is weaker in times of quantitative targeting; the observed concentration of impact suggests highly segmented market niches. The empirical findings invite attention of monetary policymakers to the financial system and its structural impediments, especially in an environment of economic uncertainty, low market confidence, and a binding interest rate floor.