By Central Bank News
A cut in short-term interest rates by central banks during an economic recession does not necessarily lead to a fall in long-term interest rates, according to a study in the Bank of Canada’s Summer Review.
Central banks typically use open market operations to control short-term interest rates and rely on this signal to be transmitted to the economically important long-term rates that govern the cost of credit to consumers and businesses.
But this transmission mechanism has not always worked as expected. In 2004-2005 when the U.S. Federal Reserve raised its policy rates to slow growth, long-term rates actually declined, a phenomenon famously described as a “conundrum” by then Fed Chairman Alan Greenspan.
But a new model used by Bank of Canada economists shows that long-term rates are determined by two factors and this helps explain the conundrum, which in fact was part of a global phenomenon.
The first, and traditional factor, is investors’ expectations of the future direction of short-term rates. These expectations are typically based on either actions or statements from the central bank.
The second factor is the extra return that investors demand for holding a risky asset. The two economists find this risk premium is largely driven by global macroeconomic conditions. If the economy is slowing down, investors demand a higher yield to hold on to long-term bonds.
“In particular, it is strongly countercyclical, rising sharply during global recessions and falling during global expansions,” the article said, adding:
“This is an important phenomenon that central banks must consider in their monetary policy decision-making process. For example, markets may be pushing down long-term interest rates at the same time that tightening by central banks would be acting to raise them. Thus, in order to have the required effect on long-term rates, a larger move in the short-term policy rate may be necessary.”
Click to read the article: “Global risk premiums and the transmission of monetary policy“
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