Report

Interest rate conundrums in the twenty-first century


Abstract: Long-term nominal interest rates are known to be highly sensitive to high-frequency (daily or monthly) movements in short-term rates. We find that, since 2000, this high-frequency sensitivity has grown even stronger in U.S. data. By contrast, the association between low-frequency changes (at six- or twelve-month horizons) in short- and long-term rates, which was also strong before 2000, has weakened substantially. We show that this puzzling post-2000 combination of high-frequency ?excess sensitivity? and low-frequency ?decoupling? of short- and long-term rates arises because increases in short rates temporarily raise the term premium on long-term bonds, leading long rates to temporarily overreact to changes in short rates. The post-2000 frequency-dependent sensitivity of long-term rates can be understood using a model in which (i) declines in short rates lead to outward shifts in the demand for long-term bonds (for example, because some investors ?reach for yield?) and (ii) the arbitrage response to these demand shifts is slow. We discuss the implications of our findings for the transmission of monetary policy and the validity of the event-study methodologies.

Keywords: monetary policy transmission; conundrum; interest rates;

JEL Classification: E43; E52; G12;

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Bibliographic Information

Provider: Federal Reserve Bank of New York

Part of Series: Staff Reports

Publication Date: 2018-06-01

Number: 810

Pages: 78 pages

Note: Previous title: “Interest Rate Conundrums in the Twenty-First Century”