WASHINGTON — Monetary policy has been "less constrained" by the zero lower bound for interest rates than is often thought, and the Federal Reserve's unconventional actions may have minimized the impact of the super-low federal funds rate on medium- and longer-term rates, new research from the Federal Reserve Bank of San Francisco shows Monday.

Senior Research Advisor Eric Swanson writes in the bank's latest Economic Letter, that "monetary policy was less constrained by the zero lower bound between 2009 and 2012 than is often recognized."

The federal funds rate, which is the interest rate at which depository institutions lend balances to each other overnight, has traditionally been the Fed's monetary policy tool of choice. But since Dec. 2008, that rate has been set by the Federal Open Market Committee at between zero and 0.25%, leaving the Fed to pursue other monetary policy tools to spur growth - including buying $85 billion a month in Treasuries and agency mortgage-backed securities.

While the zero lower bound has substantially constrained the federal funds rate, Swanson writes, "medium- and longer-term interest rates have been much less affected."

"To the extent that the Fed can affect these longer-term interest rates through forward guidance and large-scale purchases of longer-term bonds, the zero lower bound appears not to have constrained monetary policy as much as is sometimes believed, he writes."

With the lower bound of the rate held at zero for the past four and a half years, very short-term interest rates have been constrained, but "two-year Treasury yields do not appear to have been significantly affected until late 2011, and 10-year Treasury yields remained almost unaffected," Swanson writes. "Thus, there was still significant room for monetary policy to affect yields and the economy through the end of 2012."

Two possible reasons for reduced impact of the zero lower bound: First, markets expected the funds rate to lift off from zero within about four quarters, "minimizing the effects of the zero bound on medium- and longer-term yields," Swanson writes.

Second, "the Fed's unconventional policy actions seem to have helped offset the effects of the zero bound on medium- and longer-term rates," he said.

This suggests that, despite the zero bound, the Fed has been able to continue conducting monetary policy through medium- and longer-term interest rates by using forward guidance and large-scale asset purchases.

"What matters more for the economy is how changes in the fed funds rate pass through to other interest rates that are more relevant for businesses and consumers, such as the prime rate for business loans and interest rates on corporate bonds, auto loans, and mortgages" Swanson writes. "These loans generally have terms of several months or years, not just one night."

To determine the Fed's ability to continue conducting monetary policy in light of the zero lower bound, Swanson looked at how Treasuries of different maturities responded to macroeconomic announcements, such monthly employment, GDP and consumer price inflation figures.

"These announcements have important implications for the U.S. economy and future monetary policy, and thus tend to move interest rates of all maturities," he said. The three-month Treasury securities were "partially, but not completely, unresponsive to news," Swanson writes.

Meanwhile, the two-year Treasury yield's sensitivity to news "was less attenuated than that of the three-month yield." Beginning in 2011 yields of the two-year "became significantly less sensitive than normal to news," he write, but was still partially responsive until late 2012.

"Thus, to the extent that the Fed can influence monetary policy expectations over a two-year horizon, the implication is that monetary policy was about as effective as usual until at least late 2011," Swanson said.

The sensitivity of the 10-year yield to the economic data points "was never significantly less than normal" over the 2008 to 2012 period studied by Swanson.

"Even in late 2011 and 2012, when medium-term Treasury yields were more constrained, long-term yields remained largely unaffected by the zero lower bound, except possibly in the last few weeks of 2012, when the 10-year yield's sensitivity did fall appreciably below normal," he writes.

These results also have interesting implications for fiscal policy, Swanson said. "If monetary policy is constrained by the zero lower bound, then fiscal policy is generally more powerful because monetary policy and interest rates won't respond to changes in fiscal policy. In other words, at the zero lower bound, interest rates will not 'crowd out' the effects of fiscal policy."

The results "suggest that longer-term interest rates - which matter more for private sector spending - were not significantly constrained by the zero lower bound until at least late 2011. So it's unlikely that the effects of fiscal policy were much greater than normal before then," he said.

If true, this is at least a touch of good news for markets worried about ongoing fighting in Washington about fiscal policies, namely a continuing resolution to fund the government and raising the debt ceiling, without which the government would default on payment obligations later this month.

Market News International is a real-time global news service for fixed-income and foreign exchange market professionals. See www.marketnews.com.

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