Monetary Policy and Market Interest Rates

Understanding the relationship between monetary policy and market interest rates is of utmost importance to bond traders and central bankers alike. Unanticipated changes in monetary policy strongly affect interest rates of almost all maturities, representing recurrent opportunities for traders to win or lose money. All serious bond analysts have their own quantitative model of the past relationship between policy moves and the yield curve. Policy makers on the other hand carefully watch the yield curve for news about market expectations. Academic economists are interested too: the effect of monetary policy on the real economy is one of our discipline’s more controversial topics. Given these efforts, our understanding of yield curve movements remains remarkably incomplete. True, there are some statistical regularities. It is empirically well established that monetary policy affects market interest rates, and that on average this relationship is positive: an increase in the central-bank rate leads to an increase in interest rates of all maturities. It is also well known, however, that there are many exceptions to the rule. For example, on a number of occasions in 1994 when the Federal Reserve announced an increase in its target rate, interest rates of long maturities fell. As noted by