CAN MONETARY POLICY INFLUENCE LONG‐TERM INTEREST RATES? IT DEPENDS

I. INTRODUCTION A stated goal of U.S. monetary policy is to maintain full employment in the U.S. economy. (1) To do so, however, means the Federal Reserve must be capable of stabilizing aggregate demand, particularly the historically volatile category of investment spending. As this form of spending is highly sensitive to long-term interest rates, one implication of the full employment goal for U.S. monetary policy is that the Federal Reserve should be able to influence long-term interest rates. An important question, then, is whether U.S. monetary policy actually has any meaningful influence over long-term interest rates. A number of studies in recent years have examined this question, but have come to different conclusions. Some studies show monetary policy has a sizeable and statistically significant effect on long-term interest rates, whereas others show the opposite. The uncertainty created by this lack of consensus makes it difficult for the Federal Reserve to determine its impact on long-term interest rates. It is our objective in this paper to shed new empirical light on this murky relationship between monetary policy and long-term interest rates. We do so by looking at monetary policy innovations to the monetary base in an estimated vector autoregression (VAR) to see how monetary policy shocks impact the entire term structure of U.S. Treasury interest rates. (2) Other studies that have used VARs to examine this relationship have relied on innovations to the federal funds rate as their measure of monetary policy shocks (Berument and Froyen 2006; Berument and Froyen 2009; Edelberg and Marshall 1996; Evans and Marshall 1998). This approach has become problematic as the federal funds rate has grown to be more predictable in recent times and thus less capable of generating monetary policy surprises in estimated VARs. Our approach does not have this problem. Our study also has richer results than found in previous studies because we identify shocks to the money multiplier and real money demand in addition to the policy shock to the monetary base. This allows us to examine the effect of all three monetary shocks on long-term interest rates. A final improvement that our study brings to this literature is that it uses long-run identifying restrictions. Previous studies rely on short-run contemporaneous restrictions that constrain the short-run dynamics of the VAR. Our long-run restrictions avoid this issue while at the same time imposing long-run monetary neutrality on the monetary shocks. For these reasons our study provides a fresh take on the relationship between monetary policy and long-term interest rates. Using this approach, we find that contrary to what the previous VAR studies show, the Federal Reserve can meaningfully influence the entire term structure of interest rates. We also find, however, that Federal Reserve can do so only if it maintains its inflation-fighting credibility. The rest of the paper proceeds as follows. First, we review previous findings on this issue and use them to help motivate our study. Second, we outline the empirical methods we use to estimate the relationship between monetary policy shocks and long-term interest rates. Third, we discuss our data and construction of endogenous variables. Fourth, we report our findings and examine how the results change over sub-periods. Fifth, the robustness of our findings are checked by examining how important the Faust and Leeper (1997) critique is to our identification strategy. Finally, we conclude by discussing the implications for monetary policy. II. PREVIOUS FINDINGS MOTIVATING THIS STUDY Over the past decade there has been a spate of studies on the relationship between monetary policy and long-term interest rates. The methods and findings from this empirical research can be grouped into two categories. On one hand there have been a number of studies using single-equation models with daily data that find unanticipated changes in the federal funds rate can have a statistically significant and sizeable effect on long-term interest rates (Beechey 2007; Berument and Froyen 2009; Cochrane and Piazzesi 2002; Ellingsten and Soderstrom 2003; Ellingsen, Soderstrom, and Masseng 2004; Gurkaynak, Sack, and Swanson 2005; Kuttner 2001; Poole et al. …