MONETARY POLICY AND LONG‐TERM INTEREST RATES: A SURVEY OF EMPIRICAL LITERATURE

This paper surveys recent empirical literature on effects of monetary policy on long-term interest rates. Most studies reviewed here suggest that tightening monetary policy results in higher long-term interest rates. But available evidence suffers from conceptual and empirical problems and fails to indicate the magnitude of short-run and long-run policy effects on long rates. Also, recent studies have not investigated the possibility of shifts in recent-year effects of monetary policy on long rates. Finally, the paper offers a policy perspective on limitations of existing evidence and suggests future research on monetary policy effects on long rates. I. INTRODUCTION In the first half of 1994, a moderate monetary policy tightening led to sharp increases in long-term interest rates. Contrary to popular press commentary, the rise in long rates in response to a restrictive monetary policy is not surprising. Financial innovations and structural changes over the last decade may have made long rates more sensitive to monetary policy than in the past. Yet, other recent monetary policy changes did not induce sharp changes in long rates. In 1992, for example, long rates' response to monetary policy changes was less than earlier experience would suggest. Differences in long rate movements associated with different monetary policy episodes may simply reflect developments in other financial and nonfinancial determinants of long rates. A literature review should: (i) indicate whether long rates' recent response to monetary policy is in fact unusual, (ii) provide at least a rough sense of the magnitude and timing of the effect that a given monetary policy change will have over the short run versus the long run (important information since long rates play a central role in capital formation and economic activity), (iii) help assess the need for a fresh investigation of this subject. This paper provides such a review. The review is not intended to be comprehensive, only to offer a broad overview of results. The main focus is on nominal interest rates, although the paper considers studies of both nominal and real interest rates. II. OVERVIEW OF MONETARY POLICY EFFECTS ON LONG-TERM INTEREST RATES In the short run, monetary policy tightening lowers bank reserves, deposits, and loans. At the same time, it pushes up the federal funds rate and other short-term interest rates. Higher short-term interest rates, working through substitution and expectational effects, tend to increase long-term interest rates. These short-run or direct effects on long rates generally run in the same direction as those on short rates, but the magnitude is uncertain. For example, the expectations and liquidity preference theories of term structure point to a rise in long rates when short rates move up even though the two theories embody significantly different assumptions about the risk premium on long rates. One notable exception is the Fisher price expectations effect, which works to reduce long rates because a tighter monetary policy results in anticipations of lower future inflation. However, how quickly this effect actually materializes is an empirical issue. Higher interest rates lead to a weaker economy, and the feedback effects from lower actual/expected output and inflation--together with the Fisher price expectations effect--tend to reverse at least a part of the original increase in long-term interest rates. The extent of the feedback and other effects depends on many factors, including the size of actual/perceived changes in output and inflation and the extent to which changes in policy are fully anticipated. Consequently, the net long-run or equilibrium effect of monetary policy actions on long-term interest rates is theoretically ambiguous and is a matter for empirical analysis. However, many economists believe that in the long run the feedback and the Fisher price expectations effects dominate the liquidity and other direct influences so that a tighter monetary policy eventually results in lower (not higher) interest rates (see Friedman, 1968; Cagan, 1972; Patinkin, 1992). …