The excess sensitivity of long-term interest rates: evidence and implications for macroeconomic models

This paper demonstrates that long-term forward interest rates in the U.S. often react considerably to surprises in macroeconomic data releases and monetary policy announcements. This behavior is in contrast to the prediction of many macroeconomic models, in which the long-run properties of the economy are assumed to be time-invariant and perfectly known by all economic agents: Under those assumptions, the shocks we consider would have only transitory effects on short-term interest rates, and hence would not generate large responses in forward rates. Our empirical findings suggest that private agents adjust their expectations of the long-run inflation rate in response to macroeconomic and monetary policy surprises. We present an alternative model that captures this behavior. Consistent with our hypothesis, forward rates derived from inflation-indexed Treasury debt show little sensitivity to these shocks, indicating that the response of nominal forward rates is mostly driven by inflation compensation. In addition, we find that in the U.K., where the long-run inflation target is known by the private sector, long-term forward rates have demonstrated little excess sensitivity since the Bank of England achieved independence in mid-1997.

Introduction

Currency flows have always been a leading policy concern, especially in emerging markets. The long Japanese slump, the ensuing very low interest rates in Japan that have lasted 20 years, and the carry trades this fostered made currency flows a hot topic again, even before the global financial crisis increased liquidity in all developed economies and led to a new wave of currency flows to emerging market economies

Convergence and anchoring of yield curves in the euro area

We study the convergence of European bond markets and the anchoring of inflation expectations in euro area countries using high-frequency bond yield data for France, Germany, Italy and Spain. We find that Economic and Monetary Union (EMU) has led to substantial convergence in euro area sovereign bond markets in terms of interest rate levels, unconditional daily fluctuations, and conditional responses to major macroeconomic data announcements. Our findings also suggest a substantial increase in the anchoring of long-term inflation expectations since EMU, particularly for Italy and Spain, which since monetary union have seen their long-term interest rates become much lower, much less volatile, and much better anchored in response to news. Finally, the reaction of far-ahead forward interest rates to macroeconomic announcements has converged substantially across euro area countries and even been eliminated over time, thus underlining not only market integration but also the credibility that financial markets attach to monetary policy in the euro area. JEL Classification: E52, E58anchoring, bond markets, convergence, credibility, EMU, euro area, monetary policy

Does inflation targeting anchor long-run inflation expectations? evidence from long-term bond yields in the U.S., U.K., and Sweden

We investigate the extent to which inflation targeting helps anchor long-run inflation expectations by comparing the behavior of daily bond yield data in the United Kingdom and Sweden--both inflation targeters--to that in the United States, a non-inflation-targeter. Using the difference between far-ahead forward rates on nominal and inflation-indexed bonds as a measure of compensation for expected inflation and inflation risk at long horizons, we examine how much, if at all, far-ahead forward inflation compensation moves in response to macroeconomic data releases and monetary policy announcements. In the U.S., we find that forward inflation compensation exhibits highly significant responses to economic news. In the U.K., we find a level of sensitivity similar to that in the U.S. prior to the Bank of England gaining independence in 1997, but a striking absence of such sensitivity since the central bank became independent. In Sweden, we find that forward inflation compensation has been insensitive to economic news over the whole period for which we have data. Our findings support the view that a well-known and credible inflation target helps to anchor the private sector's perceptions of the distribution of long-run inflation outcomes.Inflation (Finance) ; Prices ; Monetary policy

Convergence and anchoring of yield curves in the Euro area

We study the convergence of European bond markets and the anchoring of inflation expectations in euro area countries using high-frequency bond yield data for France, Germany, Italy and Spain. We find that Economic and Monetary Union (EMU) has led to substantial convergence in euro area sovereign bond markets in terms of interest rate levels, unconditional daily fluctuations, and conditional responses to major macroeconomic data announcements. Our findings also suggest a substantial increase in the anchoring of long-term inflation expectations since EMU, particularly for Italy and Spain, which since monetary union have seen their long-term interest rates become much lower, much less volatile, and much better anchored in response to news. Finally, the reaction of far-ahead forward interest rates to macroeconomic announcements has converged substantially across euro area countries and even been eliminated over time, thus underlining not only market integration but also the credibility that financial markets attach to monetary policy in the euro area.Bond market

Inflation Targeting and the Anchoring of Inflation Expectations in The Western Hemisphere

We investigate the extent to which long-run inflation expectations are well anchored in three western hemisphere countries—Canada, Chile, and the United States—using a high-frequency event-study analysis. Specifically, we use daily data on far-ahead forward inflation compensation—the difference between forward rates on nominal and inflation-indexed bonds—as an indicator of financial market perceptions of inflation risk and the expected level of inflation at long horizons. For the United States, we find that far-ahead forward inflation compensation reacts significantly to macroeconomic data releases, suggesting that long-run inflation expectations are not completely anchored. In contrast, the Canadian inflation compensation data do not exhibit significant sensitivity to either Canadian or U.S. macroeconomic news, consistent with the view that inflation targeting in Canada has been successful in anchoring long-run inflation expectations. Finally, while the requisite data for Chile is only available for a limited sample period (2002-2005), our results are consistent with the hypothesis that inflation targeting in Chile has also succeeded in anchoring long-run inflation expectations.

INFLATION TARGETING AND THE ANCHORING OF INFLATION EXPECTATIONS IN THE WESTERN HEMISPHERE

We investigate the extent to which long-run inflation expectations are well anchored in Canada, Chile, and the United States, using a high-frequency event-study analysis. Specifically, we use daily data on far-ahead forward inflation compensation as an indicator of financial market perceptions of inflation risk and the expected level of inflation at long horizons. For the U.S., we find that far-ahead forward inflation compensation reacts significantly to macroeconomic data releases, implying that long-run inflation expectations are not completely anchored. In contrast, the Canadian inflation compensation data does not exhibit significant sensitivity to either Canadian or U.S. macroeconomic news, confirming that inflation targeting in Canada has succeeded in anchoring long-run inflation expectations. Finally, while the requisite data for Chile is available only for a limited sample period (2002-05), our results are consistent with the hypothesis that inflation targeting in Chile has also succeeded in anchoring long-run inflation expectations.