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Explaining the increased variability in long-term interest rates.”Federal Reserve Bank Richmond Economic Quarterly

By Mark W. Watson


Monetary policy affects the macroeconomy only indirectly. In the standard mechanism, changes in the federal funds rate, the Federal Reserve’s main policy instrument, lead to changes in longer-term interest rates, which in turn lead to changes in aggregate demand. But the links between the funds rate, long rates, and demand may be far from tight, and this potential slippage is a fundamental problem for monetary policymakers. In particular, long-term interest rates sometimes move for reasons unrelated to short-term rates, confounding the Federal Reserve’s ability to control these long-term rates and effect desired changes in aggregate demand. Has the link between long rates and short rates weakened over time, therefore making it more difficult for the Federal Reserve to achieve its macroeconomic policy objectives through changes in the federal funds rate? Such questions naturally arise when one observes the behavior of longterm interest rates. For example, Figure 1 plots year-to-year changes in ten-year Treasury bond yields from 1965 through 1998. (The volatile period of the late 1970s and early 1980s has been masked to highlight differences between the early and later periods.) The most striking feature of the plot is the increase in the variability of long-term rates in the recent period relative to the earlier period. Indeed, the standard deviation of long rates essentially doubled across the two time periods. What caused this increase in variability? Did a change i

Year: 1999
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