Three essays on the interaction of monetary policy and long -term interest rates.

Abstract

The chapters in this dissertation study three issues related to the interaction of monetary policy and long-term interest rates, paying special attention to inflation expectations embedded in market interest rates. Does the Fed react to the bond rate only because it is an information carrier, or does the bond rate act as if it is an additional policy target of the Fed? Using GMM estimation of versions of forward-looking monetary policy rules, strong evidence is found in support of the latter claim. In particular, Chapter 1 finds that the bond rate has incremental explanatory power for the Fed funds rate after controlling for its contribution to predicting the Fed's inflation and output targets. To motivate the empirical results, this chapter constructs a rational expectations model in which the Fed attempts to smooth the bond rate. The bigger the weight assigned to this objective, the larger the observed correlation between the Fed funds rate and the bond rate. How does long-term expected inflation respond to monetary policy? Extracting inflation expectations from the long-term forward spot interest rate, Chapter 2 finds the puzzling result that it does not fall most of the time after Fed tightening. This seems to be exactly the opposite of what deflationary monetary policy aims to achieve and is not consistent with standard theories. A political economy model with regime switching seems to be able to rationalize the puzzle. How does the financial market react to economic news? Using information from the newly issued U.S. indexed bonds (TIPS) Chapter 3 obtains new results regarding how the TIPS price, nominal yield, real yield and expected inflation respond to surprises in CPI inflation, PPI inflation, the unemployment rate and the change of payrolls. With the help of information from the Fed funds futures market, a detailed profile of how these variables respond to the anticipated and surprise components of monetary policy announcements is also estimated. This chapter also demonstrates that considering the indexation lag is critical in obtaining correct responses to CPI news.