Yield Expectations and Monetary Policy
17 Pages Posted: 13 Feb 2010 Last revised: 10 Jan 2012
Date Written: January 8, 2012
This paper applies a yield curve model that separates expectations and volatility components of market yields on default-free bonds. Expected future riskless rates derived from the model are unbiased, reasonably accurate indicators of subsequent actual riskless rates for periods up to three years.
Variances between Fed Funds and expectations of future riskless rates derived from the model correspond with incidences of tight money and easy money in the past and are reflected in subsequent inflation rates three years out. Ex-post inflation forecasts based upon these variances have accuracy within the range of alternative forecasts.
Given this direct relationship with future inflation, expectations of future riskless rates may be useful as an indicator or policy target for inflation-targeting monetary policy. For this purpose, robust “headline” inflation measures produce the strongest relationship and may be more useful than “core” measures. Difficulties stimulating the Japanese economy and, recently, the U.S. and other economies might arise from limits on the magnitude of potential monetary stimulus when yield expectations are at extremely low levels and policy rates are zero bound.
Keywords: Monetary Policy, Monetary Policy Rules, Yield Curve, Expectations, Term Structure
JEL Classification: E31, E32, E43, E44, E50, E52
Suggested Citation: Suggested Citation