Monetary Policy and the Term Structure of Interest Rates When Short-Term Rates Are Close to Zero

The zero lower bound on nominal interest rates can affect the effectiveness of monetary policy potentially in two ways. First, it limits the size of a change in the policy interest rate when trying to loosen money. For example, when the nominal rate is 0.5 percent, it obviously cannot be cut by more than 0.5 percent. Second, it may alter the mechanism of how a movement of the policy rate drives market rates of longer maturities. This paper is an attempt to investigate the latter issue, and, in particular, to empirically examine the effect of monetary policy on the term structure of interest rates when nominal short-term rates are close to zero, using Japanese data in the 1990s and early 2000s. We found that when the policy short rate is already zero but longer rates are still positive in the zero interest rate period, an expansionary monetary policy still works through the conventional interest rate channel by pushing down longer rates, although the effect is much weakened relative to the normal time. When the longer rates are already lowered to some level, however (for example, the 10-year bond rate went down to the level as low as 1.5 percent during the quantitative easing period of 2001-06), a further expansion of the monetary base by increasing excess reserves of banks appears to have little effect in lowering longer-term rates.