WASHINGTON - Changes in monetary policy have "surprisingly strong" effects on forward real rates far down the road, according to research by a Federal Reserve policymaker, noting that a 100 basis-point increase in the 2-year nominal yield on an FOMC announcement day is associated with a 42 basis-point increase in the 10-year forward real rate.
In the first draft of a paper on 'Monetary Policy and Long-Term Real Rates' published Thursday, Fed Gov. Jeremy Stein said while this finding is at odds with standard macro models based on "sticky nominal prices," the responsiveness of long-term real rates to monetary shocks most likely reflect changes in term premia.
"Changes in the stance of monetary policy have a surprisingly strong impact on distant forward real interest rates," Stein and his co-author, Samuel Hanson of Harvard, wrote.
"These movements in forward rates appear to reflect changes in term premia, which largely accrue over the next year, as opposed to varying expectations about future real rates," they said.
The authors added that, "Moreover, our evidence suggests that the driving force behind time-varying term premia is the behavior of yield-oriented investors, who react to a cut in short rates by increasing their demand for longer-term bonds, thereby putting downward pressure on long-term rates."
The paper said its findings can be illustrated by the Federal Open Market Committee's announcement following its January 25 meeting.
That day, the Fed's policymaking body changed its forward guidance on interest rates, extending the calendar date it expected to hold the federal funds rate near zero to "through late 2014" from "through mid-2013."
Stein and Hanson noted that in response to this announcement, the expected path of short-term nominal rates fell significantly from two to five years out, with the 2-year nominal yield dropping by 5 bps and the 5-year nominal yield by 14 bps.
"More strikingly, 10-year and 20-year real forward rates declined by 5 bps and 9 bps respectively," they said. "In other words, distant real forward rates appeared to react strongly to news about the future stance of monetary policy."
They acknowledged that the paper "raises, but does not answer," a series of questions about the ultimate economic importance of this monetary transmission channel.
"In particular, suppose that a monetary easing lowers long-term real rates through the mechanism we have described. What might the resulting impact on corporate investment be?" they asked.
"On the one hand, the fact that the effect of monetary policy on long-term real rates is transitory (i.e., it is reversed after about a year) might seem to imply that it would matter less for corporate capital budgeting decisions," the paper said.
"On the other hand, some firms may view the temporarily lower long-term rates as a market-timing opportunity, i.e., a window during which it is particularly attractive to issue long-term debt. This in turn could serve to stimulate their investment," it added.
Stein and Hanson said while they focused on just term premia in the Treasury market, the idea that monetary policy can influence bond-market risk premia "has potentially broader implications."
"Indeed, much recent work has been motivated by the hypothesis that accommodative monetary policy can reduce credit-risk premia. It seems like a promising avenue for future work would be to study these two channels of monetary transmission in a unified setting," they said.