Monetary Policy and Long-Term Interest Rates

Author(s): H. Sonmez Atesoglu

Source: Journal of Post Keynesian Economics, Vol. 27, No. 3 (Spring, 2005), pp. 533-539
Published by: M.E. Sharpe, Inc.
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534 JOURNAL OF POST KEYNESIANECONOMICS

Figure 1 Federalfunds rateand AAA bond rate

12

8--

.. ^/

..

v<

\ *

/i

6-4~~~~~~1

2 I-----------

88

90

AAA

92

94

96

98

FF
"-

00

IY

02

Monetarypolicy actionsof the FederalReserve arerepresentedby the

federalfundsrate.Theperiodof analysisspans 1987:02through2004:04.
During this period, the federal funds rate has been explicitly identified
as the operatingtargetof the FederalReserve. FederalReserve implements monetarypolicy by changing the level of the federal funds rate
target.Federal Reserve maintainsthe targetlevel of the federal funds
rate by adjustingthe supply of bank reserves. Changes in the federal
fundsrateengineeredby the FederalReservepass throughto long-term
marketinterestrates.
Federal funds rate and long-term interest rates
Pathsof the AAA bond yield (AAA) and the 30-yearTreasurynote rate
(TN30) along with the federalfundsrate(FF) arepresentedin Figures 1
and 2.2 These figures show that the spread (the vertical distance between the lines in each figure) between AAA and FF and the spread
between TN30 and FF are quite volatile from one periodto the next. In
the long run, however,AAA and FF and TN30 and FF seem to move
together.The behaviorof these long-terminterestrates with respect to
the federalfundsratecontrastwith thatof the behaviorof the primerate
2 The source of data is FRED II, St. Louis FederalReserve Bank, June 2, 2004.
Figure 1 is for 1987:02-2004:04, and Figure2 is for 1987:02-2002:01, because data
for TN30 are not availableafter2002:01. AAA is Moody's Aaa bond yield.

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MONETARYPOLICYAND LONG-TERMINTERESTRATES 535

Figure 2 Federalfundsrateand30-yearnoteyield
10-

5-

'

4-

3-"
,--

88

90

92

94

TN30 --

96

98

FF

00

(a short-terminterest rate) with respect to the federal funds rate discussed by Atesoglu (2003-4). His findings from 1987:02-2002:05 revealedthatin additionto an empiricallyclose andstablerelationbetween
the FF and the primerate,especially after 1994:01, the spreadbetween
the primerate and FF is practicallyconstant.

Cointegrationanalysis
Empiricalresults obtainedfor the relationsbetween AAA and FF, and
TN30 and FF employing the Johansencointegrationand vector error
correctionmodelingtechniquearepresentedin Table 1. For comparison
with these results, OLS (ordinaryleast squares)estimates are also presented.Johansenresults indicatethatthereis a positive and empirically
stable long-runrelation,a cointegrationrelation,betweenAAA and FF,
andTN30 andFF.3OLS resultsalso indicatea comparablepositive relation between FF and long-termrates.
Note that the cointegrationcoefficient is around0.6 for both cointegration equations, indicatingthat, in the long run, there is a less than
complete pass-throughfrom the federal funds rate to these long-term
interestrates.These findingscontrastwith those of Atesoglu (ibid.) for
3 AugmentedDickey-Fuller tests indicatethat the AAA, TN30, and FF can be
assumedto have a unit root. Estimationswere madeby using the EViews 4 (Quantitative Micro Software).

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536 JOURNAL OF POST KEYNESIANECONOMICS

Table 1
Federal funds and long-term interest rates, OLS, and Johansen
estimates

OLS
Johansen

Dependent
variable

Intercept

FF

RF

MA
AAA

5.543
3.424

0.433
0.720
(5.099)

0.618

AFF

0.015
(0.735)
-0.057
(-2.603)

AAAA
OLS
Johansen

TN30
TN30

Errorcorrection
term

4.881
0.582

0.403
0.575
(1.065)

0.340

AFF

-0.005
(-0.891)
ATN30
-0.022
(-3.334)
Notes:AAA is the corporatebondyield,FF is thefederalfunds,andTN30 is the 30-year
Treasurynoteyield. Sampleperiod:1987:02-2004:04for AAA relationsand1987:022002:01for TN30relations.Valuesin parenthesesaret-statistics.TheJohansen
cointegrationtests assumeno lineardeterministictrend;lag interval(in firstdifferences):1
to 35 monthsfor AAA estimatesand 1 to 43 monthsforTN30 estimates.Forboth
cointegrationequations,the tracetestsindicateone cointegrationequationat the 5 percent
level.

the relationbetween FF andthe primerate.His resultshave shown that,

in the long run,thereis almosta completepass-throughbetweenFF and
theprimerateanda completepass-throughto theprimerateafter1994:01.
Vector errorcorrectionmodels were estimatedfor the cointegration
relationsbetween AAA andFF and 30TN and FF. The errorcorrection
termsfromthe vectorerrorcorrectionmodels (the lagged residualof the
estimatedcointegrationequations)presentedin Table 1 are significant
determinantsof both the change in AAA corporatebond yield, AAAA,
and the change in 30-year Treasurynote yield, ATN30. But, the error
correctionterms for the change in the federal funds rate, AFF, are not
significant.These resultsindicatethatwhile the AAA and TN30 adjust
in maintainingthe cointegrationrelations,the FF does not. These findings imply a unidirectionalcausality that runs from the federal funds
rateto the AAA corporatebondyield, anda unidirectionalcausalitythat
runsfrom the federalfunds rate to the 30-yearTreasurynote yield.

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MONETARYPOLICYAND LONG-TERMINTERESTRATES 537

Figure 3 Response of AAA to FF

.25
.20-

.15
.10.055

10

15

20

25

30

35

Months
The estimatederrorcorrectiontermsfor AAAA and for ATN30 indicate, respectively, that only about 0.06 and 0.02 percentof the adjustment in AAA and TN30 rate are completed within one month afterthe
change in the federalfundsrate.These findingsfor the relationbetween
the federal funds rate and the long-term interest rates contrast with
Atesoglu (ibid.), where he reportslarge adjustmentsin the prime rate
within one monthafterthe change in the federalfunds rate.
In Figures 3 and 4, the effect of FF changes on AAA and 30TN are
presented.4These results are obtainedfrom the vector errorcorrection
models mentionedabove thatwere estimatedfor the cointegrationrelation between AAA and FF, and 30TN and FF. Figure 3 shows that, in
response to an appreciableincrease in FF, AAA rises very little in the
first 12 monthsandreachesits peakresponse,around0.25 percent,after
about30 months.As seen in Figure4, the response of TN30 is weaker.
In responseto a considerablerise in FF duringthe first 18 months,TN30
at times becomes negative, and the peak effect of only about 0.14 percent is reachedafterabout30 months.These results as a whole suggest
thatFederalReserve actions,in the form of changes in the federalfunds
rate,do have an appreciableeffect on long-terminterestratesin the long

4 Responses depictedare for the one standarddeviationgeneralizedimpulses. See

EViews4, User's Guide, ch. 20 (QuantitativeMicro Software).

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538 JOURNAL OF POST KEYNESIANECONOMICS

Figure 4 Responseof 30TNto FF

.25
.20
.15-

.10.05-

.00
-.05-

10

. , .

15

. , ..

... .

20
25
Months

i.

30

35

run. But, FederalReserve actions do not have as much of an effect on

long-terminterestratesin the shortrun,thatis, duringthe firstyearafter
a change in the federalfunds rate.

Conclusion
The findings discussed above are consistent with a monetarytransmission mechanism in which changes in the federal funds rate, brought
about by the FederalReserve throughopen marketoperations,lead to
changes in long-term interestrates.5These findings are supportiveof
the interest rate channel of monetary transmission through financial
marketsand complementfindings of Atesoglu (ibid.) for the monetary
transmissionthrough the banking system. The findings, by revealing
thatthereis an empiricallystable long-runrelationand a unidirectional
causalityfrom the federalfunds rateto the long-terminterestrates, are
supportiveof the horizontalistratherthan the structuralistview of the
money supply endogeneity.6
5 For a discussion of the

portfoliochange process the FederalReserve can administer throughopen-marketoperationsthatcan lead to changes in interestrates, see
Davidson (2002, ch. 5).
6
Structuralistand horizontalistexplanationsof money supply endogeneity are
discussed by Lavoie (1996), Moore (1988; 1991), and Pollin (1991).

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MONETARYPOLICYAND LONG-TERMINTERESTRATES 539

The findings, while indicatingan empiricallystable long-runrelation

between the federal funds rate and long-terminterestrates, also reveal
that changes in the federalfunds rate do not have much of an effect on
the long-terminterestratesin the shortrun.This is unlike the large and
immediateeffect of the federalfund ratechanges on the primeratediscussed by Atesoglu (ibid.). These results raise doubts concerning the
effectiveness of monetarypolicy in the shortrunandindicatethat,in the
shortrun,the FederalReserve cannotrely on the long-terminterestrate
transmissionchannelof monetarypolicy. Proposalsfor the FederalReserve to conduct open-marketoperations,by using long-termdebt instrumentsin order to bring about changes in long-term interestrates,
agree with the above findings.7In the short run, the Federal Reserve
manipulationof the federal funds rate appearsto have strong leverage
on short-terminterestratesbut not on the long-termrates.

REFERENCES
Atesoglu, H.S. "MonetaryTransmission-Federal FundsRate and PrimeRate."
Journalof Post KeynesianEconomics,Winter2003-4, 26 (2), 357-363.
Davidson, P. Financial Markets,Moneyand Real World.Cheltenham,UK: Edward
Elgar, 2002.
Lavoie, M. "Horizontalism,Structuralism,LiquidityPreferenceand the Principleof
IncreasingRisk."ScottishJournalof Political Economy,August 1996, 43 (3),
275-300.
Mishkin,F.S. The Economicof Money,and Bankingand Financial Markets.Boston:
Addison-Wesley,2003.
Moore, B.J. Horizontalsand Verticalists.Cambridge:CambridgeUniversity Press,
1988.
. "MoneySupply Endogeniety:Reserve Pricingor Reserve QuantitySetting."
Journalof Post KeynesianEconomics,Spring 1991, 13 (3), 404-413.
Pollin, R. "Two Theoriesof Money Supply Endogeneity:Some EmpiricalEvidence."
Journalof Post KeynesianEconomics,Spring 1991, 13 (3), 366-396.
Sellon, G.H., Jr. "TheChangingU.S. FinancialSystem: Some Implicationsfor the
MonetaryTransmissionMechanism."EconomicReview,FederalReserve Bank of
KansasCity, FirstQuarter2002, 87 (1), 5-35.
. "MonetaryPolicy and the Zero Bound:Policy OptionsWhen Short-Term
Rates Reach Zero."EconomicReview,FederalReserve Bank of KansasCity, Fourth
Quarter2003, 88 (4), 5-43.

7 Difficulties with this

type of open-marketoperationare discussedby Sellon (2003).

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