Introduction | RDP 2011-02: Long-term Interest Rates, Risk Premia and Unconventional Monetary Policy

RDP 2011-02: Long-term Interest Rates, Risk Premia and Unconventional Monetary Policy 1. Introduction

Callum Jones and Mariano Kulish

April 2011

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In the recent downturn, central banks in the United States, the United Kingdom, Canada and the euro area pushed their policy rates close to their lower bound of zero, renewing interest in alternative policy instruments. These instruments, often termed unconventional monetary policies, involve both the expansion of the central bank's balance sheet through purchases of financial securities and announcements about future policy that explicitly aim to influence expectations. Both of these policies aim to lower borrowing costs and stimulate spending. As Dale (2010) and Gagnon et al (2010) emphasise, the financial crisis highlighted the importance of understanding alternative ways to conduct monetary policy.

One possibility is for the central bank to purchase long-term securities in order to push down longer-term nominal interest rates. Indeed, the Bank of Japan, and more recently the Federal Reserve and the Bank of England, have pursued purchases of long-term assets.^[1] Bernanke (2002) was one of the first to discuss this option,^[2] while Clouse et al (2003) provided more detail. As Figure 1 shows, even when short rates have been close to zero in the recent episode, long rates have remained well above, suggesting that there may be greater capacity to stimulate the economy with long-term rates rather than short-term rates.

In this paper, we consider the more direct option of using a long-term interest rate as the policy instrument. Studying this possibility is more than just theoretically important. For instance, since late 1999 the Swiss National Bank has set policy by fixing a target range for the 3-month money market rate rather than setting a target for the conventional instrument of a very short-term interest rate. Jordan and Peytrignet (2007) argue that this choice gives the Swiss National Bank more flexibility to respond to financial market developments.

Announcements about the path of the short rate are another way of influencing long-term rates. This too has recently been tried. The Bank of Canada, for example, announced on 21 April 2009 that it would hold the policy rate at ¼ per cent until the end of the second quarter of 2010, while the Sveriges Riksbank announced on 2 July 2009 that it would keep its policy rate at ¼ per cent ‘until Autumn 2010’. Also, the Federal Reserve has repeated that it intends to keep the federal funds rate low for an extended period of time.^[3] While some central banks have previously given guidance about the direction or timing of future policy, these announcements have, at the least, been interpreted as an explicit attempt to influence expectations.

Previous research suggests that long-term interest rate rules share the desirable properties of Taylor rules, can support unique equilibria, and their performance is comparable to more conventional Taylor rules.^[4] However, previous studies do not contain a risk premium, or if there is one, it is exogenous. This raises important theoretical issues about the use of long-term interest rate rules. In particular, can long-term interest rate rules achieve a unique equilibrium if an endogenous risk premium prices long-term debt? And if so, how do these rules perform and what dynamics do they entail?

In this paper, we explore these questions in the context of a model in which the risk premium is endogenous and examine two kinds of unconventional monetary policy: long-term nominal interest rates as operating instruments of monetary policy and announcements about the future path of the short-term rate.

In the next section we discuss the model which is then used in Section 3 to analyse existence, uniqueness and multiplicity of the equilibrium under long-term interest rates rules. In Section 4, we study the dynamics associated with long-term interest rate rules and in Section 5 we find their optimal settings, which we compare to those of Taylor rules. Then, in Section 6, we analyse announcements about the future path of the short rate and the transition to a new rule. s Section 7 concludes.

Footnotes

For Japan see Ugai (2006), for the United Kingdom see Joyce et al (2010), and for the United States see Gagnon et al (2010) [1]