Monetary policy and the yield curve

This paper explores the response of the yield curve to changes in the federal funds rate.  Based on a sample ending in the early 1990s, Romer and Romer (2000) find that long-term interest rates rise when the Fed increases the federal funds rate target because bond market participants interpret rate increases to mean that the Fed expects inflation to rise in the future. They further argue that the reason market participants interpret rate hikes as signaling inflation is that the Fed has historically been better than the private sector at forecasting inflation. Recent research however shows that the Fed’s forecasting superiority has diminished since the early 1990s, possibly because of Fed’s efforts to increase transparency (e.g. Gamber and Smith (2009)).

We re-examine the Romer and Romer hypothesis by directly measuring the response of the yield curve to changes in the federal funds rate. If increases in the federal funds rate reveal future inflation we expect the yield curve to shift up and/or steepen. If increases in the federal funds rate do not reveal future inflation we would expect the yield curve to remain unchanged or flatten. To the extent that increased transparency on the part of the Fed decreased the Fed’s advantage in forecasting inflation, we expect that in samples after the mid-1990s the yield curve will flatten or remain unchanged in response to federal funds rate increases.

We test this hypothesis by estimating a value at risk (VAR) with the federal funds rate or shadow federal funds rate, and measures of the level, slope and curvature (corresponding to the first three principal components) of the yield curve. We examine three samples: early Great Moderation (1984-1993), Great Moderation and greater transparency (1994-2007), and Financial Crisis and Great Recession (2008-2015).

Considering our preliminary results, we see differences that arise in the post-transparency period.  The response of the yield curve level to an innovation in the federal funds rate declined in the post-transparency period. That decline is most likely due to a reduction in the inflation target of the Fed and may not be directly related to transparency.  For the slope we see that pre-transparency the slope responded positively and post-transparency the slope did not respond at all to changes in the federal funds rate.  These results suggest that greater transparency by the Federal Reserve has resulted in more knowledge transmission about future monetary policy and less knowledge transmission about future inflation