Volatility, money market rates, and the transmission of monetary policy
Central banks typically control an overnight interest rate as their policy tool, and the transmission of monetary policy happens through the relationship of this overnight rate to the rest of the yield curve. The expectations hypothesis, that longer-term rates should equal expected future short-term rates plus a term premium, provides the typical framework for understanding this relationship. We explore the effect of volatility in the federal funds market on the expectations hypothesis in money markets. We present two major results. First, the expectations hypothesis is likely to be rejected in money markets if the realized federal funds rate is studied instead of an appropriate measure of the expected federal funds rate. Second, we find that lower volatility in the bank funding markets market, all else equal, leads to a lower term premium and thus longer-term rates for a given setting of the overnight rate. The results appear to hold for the US as well as the Euro Area and the UK. The results have implications for the design of operational frameworks for the implementation of monetary policy and for the interpretation of the changes in the Libor-OIS spread during the financial crisis. We also demonstrate that the expectations hypothesis is more likely to hold the more closely linked the short- and long-term interest rates are.
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