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This paper assesses the effect of federal funds rate innovations on longer-term US nominal interest rates across different periods. The evidence suggests that these responses change with changes in the monetary policy regime. Time periods considered are pre- and post-1979 and different Federal Reserve Chairman’s tenure. The response of longer-term interest rates to federal funds rate innovations are shown to be smaller and less persistent in the post-1979 period when the Federal Reserve placed more emphasis on inflation.

This paper examines the effects of monetary policy on long-term interest rates in the United States. Monetary policy impulses are measured by innovations in the federal funds rate which was the Federal Reserve’s policy instrument over most of the period examined. Given that the Federal Reserve conducts monetary policy in this manner, the response of longer-term rates to the federal funds rate is a key question. The focus of this study is on the way in which this response depends on the monetary policy regime. How has the response of longer-term interest rates to innovations in the federal funds rate varied with what in the literature have been identified as regime changes? This focus leads us to proceed in the following manner. First, we consider a long period 1973–2002 and focus on time-variation in the response of longer-term rates to innovations in the federal funds rate. Second, we employ weekly data and consider several ways to break the time-span considered into subperiods corresponding to different monetary policy regimes. Besides providing sufficient observations to examine a number of subperiods, weekly data are more likely to pick out actual innovations to the federal funds rate than are monthly or quarterly observations. Finally, responses of long-term interest rates to innovations in the federal funds rate are examined within a VAR framework allowing for the interaction of interest rates with other macroeconomic variables. There are a number of recent studies related to our research. Evans and Marshall, 1998, Kozicki and Tinsley, 2001a, Kozicki and Tinsley, 2001b and McMillin, 2001 study the linkage of monetary policy and short- and long-term nominal interest rates within VAR frameworks. Kuttner (2001) estimates the impact of monetary policy actions on interest rates of various maturities. Mehra, 1996, Roley and Sellon, 1995 and Thornton, 1998 study the response of longer-term interest rates to monetary policy actions measured by the federal funds rate (or target federal funds rate), as does an earlier paper by Cook and Hahn (1989). Additional empirical literature on the topic is surveyed in Akhtar (1995). This literature suggests considerable uncertainty about the response of longer-term interest rates to changes in the federal funds rate. Even the direction of the effect is a subject of disagreement. Two recent macroeconomic textbooks, for example, present divergent views. Blanchard (2000, p. 295) expresses the “standard view” that “when short-term rates move, whether down (as in the 1990–1991 recession) or up, long-term interest rates are likely to move in the same direction, but by less.” Cook and Hahn (1989) report results consistent with this view. Romer (2001, p. 477) considers Cook and Hahn’s result an “anomaly.” In his view, the “idea that a contractionary monetary policy [a rise in the federal funds rate] should immediately lower long-term nominal interest rates is intuitive: contractionary policy is likely to cause real interest rates to rise only briefly and is likely to lower inflation over the longer term.” We return to these divergent views at a later point. The paper is organized as follows. Section 2 discusses the data and sets out the VAR framework employed. Section 3 presents our results. Section 4 considers these results in the context of previous literature. Section 5 contains concluding comments.

Impulse response functions reported in Section 3 indicate that for the period 1975–2002 (or 1973–2002) monetary policy shocks, measured as innovations in the federal funds rate, have initial effects in the same direction on longer-term interest rates as measured by the 1-year and 10-year government security rates. The effect on the 1-year rate is greater in magnitude than is that for the 10-year rate. Results for impulse response functions and from variance decompositions indicate, however, that effects of innovations in the federal funds rate on these longer-term interest rates varied across the subperiods that were considered. Specifically, while innovations in the federal funds rate initially moved longer-term interest rates in the same direction the movements were smaller and less persistent in the post relative to the pre-1979 subperiod. Moreover, in the post-1979 period, after an initial movement in the same direction the impulse response functions indicate that an innovation in the federal funds rate then causes the longer-term interest rate to move in the opposite direction. A positive innovation in the federal funds rate leads, for example, to a short-lived increase in either the 1- or 10-year rate followed by a longer period where these longer-term rates decline relative to their initial values. Impulse response functions and variance decompositions for the years of Arthur Burns’s chairmanship are quite similar to those for the pre-1979 period, most of which was the Burns period. The Volcker and Greenspan chairmanships are both post-1979. Impulse response functions for the Volcker period, however, show a relatively larger and more persistent movement of the long-term rate in the same direction as the innovation in the federal funds rate and less evidence of a reversal of this effect than do those for the Greenspan period. Still, impulse response functions and variance decompositions for the Volcker and Greenspan period are consistent with the smaller effects on longer-term interest rates of innovations in the federal funds rate post-versus pre-1979. Based on the discussion in Sections 1 and 2.2, our interpretation of this time variation in the effect of monetary policy shocks is that it reflects the influence of monetary policy regime changes. The increased emphasis on an inflation goal in the post-1979 period more firmly anchored the inflationary expectations of market participants. Monetary policy shocks in the post-1979 period therefore had less effect on expected future short-term interest rates and therefore on long-term interest rates.