Volatility, Money Market Rates, and the Transmission of Monetary Policy

37 Pages Posted: 19 May 2011 Last revised: 15 Nov 2011

See all articles by Seth B. Carpenter

Seth B. Carpenter

Federal Reserve Board - Department of Monetary Affairs

Selva Demiralp

Koc University - Department of Economics

Date Written: February 1, 2011

Abstract

Central banks typically control an overnight interest rate as their policy tool, and the transmission of monetary policy happens through the relationship of this overnight rate to the rest of the yield curve. The expectations hypothesis, that longer-term rates should equal expected future short-term rates plus a term premium, provides the typical framework for understanding this relationship. We explore the effect of volatility in the federal funds market on the expectations hypothesis in money markets. We present two major results. First, the expectations hypothesis is likely to be rejected in money markets if the realized federal funds rate is studied instead of an appropriate measure of the expected federal funds rate. Second, we find that lower volatility in the bank funding markets market, all else equal, leads to a lower term premium and thus longer-term rates for a given setting of the overnight rate. The results appear to hold for the US as well as the Euro Area and the UK. The results have implications for the design of operational frameworks for the implementation of monetary policy and for the interpretation of the changes in the Libor-OIS spread during the financial crisis. We also demonstrate that the expectations hypothesis is more likely to hold the more closely linked the short- and long-term interest rates are.

Keywords: Monetary transmission mechanism, expectations hypothesis, Term premium

JEL Classification: E43, E52, E58

Suggested Citation

Carpenter, Seth B. and Demiralp, Selva, Volatility, Money Market Rates, and the Transmission of Monetary Policy (February 1, 2011). FEDS Working Paper No. 2011-22. Available at SSRN: https://ssrn.com/abstract=1845824 or http://dx.doi.org/10.2139/ssrn.1845824

Seth B. Carpenter (Contact Author)

Federal Reserve Board - Department of Monetary Affairs ( email )

20th and C Streets, NW
Mailstop 60
Washington, DC 20551
United States
202-452-2385 (Phone)
202-452-2301 (Fax)

Selva Demiralp

Koc University - Department of Economics ( email )

Rumeli Feneri Yolu
Sariyer 80910 Istanbul
Turkey
+212 338 1842 (Phone)

Register to save articles to
your library

Register

Paper statistics

Downloads
85
Abstract Views
602
rank
292,540
PlumX Metrics