It is generally believed that monetary policy actions are transmitted to the economy through their effect on market interest rates. According to this standard view, a restrictive monetary policy by the Federal Reserve pushes up both short-term and long-term interest rates, leading to less spending by interest-sensitive sectors of the economy such as housing, consumer durable goods, and business fixed investment. Conversely, an easier policy results in lower interest rates that stimulate economic activity. Unfortunately, this description of the monetary policy process is difficult to reconcile with the actual behavior of interest rates. Although casual observation suggests a close connection between Federal Reserve actions and short-term interest rates, the relationship between policy and long-term interest rates appears much looser and more variable. In addition, empirical studies that attempt to measure the impact of policy actions on long-term rates generally find only a weak relationship. Taken together, the empirical studies and the observed behavior of interest rates appear to challenge the standard view of the monetary transmission mechanism and raise questions about the effectiveness of monetary policy. This article attempts to reconcile theory and reality by reexamining the connection between monetary policy and long-term interest rates. Using a framework that emphasizes the importance of market expectations of future monetary policy actions, the article argues that the relationship between policy actions and long-term rates is likely to vary over the business cycle as financial market participants alter their views on the persistence of policy actions. Accordingly, the standard view of the monetary transmission mechanism appears to provide an overly simplistic view of the policy process. In addition, by capturing the tendency of market rates to anticipate policy actions, the article finds a larger response of long-term rates to monetary policy than reported in previous research. The first section of the article describes the standard view of the monetary transmission mechanism and examines its consistency with actual interest rate behavior. The second section uses the expectations theory of the term structure to show how the impact of monetary policy on long-term rates depends on market expectations about the future direction of policy. The third section presents new empirical estimates of the relationship between policy actions and long-term rates. MONETARY POLICY AND LONG-TERM RATES: THEORY VS. REALITY The standard view of the monetary policy transmission mechanism suggests a close relationship between Federal Reserve policy actions and market interest rates. However, while there is considerable evidence that monetary policy has predictable effects on short-term rates, the connection between policy actions and long-term rates appears to be weaker and less reliable. The monetary transmission mechanism Changes in the stance of monetary policy take place in the market for reserves held by depository institutions. The Federal Reserve can alter the supply of reserves either by using open market operations to buy or sell government securities or by altering the amount of reserves borrowed through the discount window. Providing fewer reserves than desired by depository institutions puts upward pressure on the price of reserves--the federal funds rate--while supplying more reserves than institutions desire puts downward pressure on the funds rate. In recent years, the Federal Reserve has implemented monetary policy by using open market operations to maintain a desired level of the federal funds rate (Lindsey). This "short-run operating target" is derived from longer term objectives for price stability and economic activity, and is adjusted when the Federal Reserve believes the stance of policy should be altered to better achieve its long-run objectives (Davis, Meulendyke). …

Monetary Policy Actions and Long-Term Interest Rates

We re-examine the relationships among Federal Reserve monetary-policy actions, U.S. interventions in currency markets, and exchange rates using an alternative measure of monetary policy actions, the Federal Reserve's federal funds rate target. We find that exchange rates generally respond immediately to U.S. monetary policy actions and that these responses are usually consistent with the overshooting hypothesis. We also find evidence of signaling and leaning-against-the-wind U.S. intervention policies over the sample; however, controlling for such interventions does not alter our estimates of exchange rate responses to federal funds rate target changes.

Monetary Policy Actions, Intervention, and Exchange Rates: A Re-Examination of the Empirical Relationships Using Federal Funds Rate Target Data

The authors reexamine the relationships among Federal Reserve monetary-policy actions, U.S. interventions in currency markets, and exchange rates using an alternative measure of monetary policy actions, the Federal Reserve's federal funds rate target. They find that exchange rates generally respond immediately to U.S. monetary policy actions and that these responses are usually consistent with the overshooting hypothesis. The authors also find evidence of signaling and leaning-against-the-wind U.S. intervention policies over the sample; however, controlling for such interventions do not alter their estimates of exchange rate responses to federal funds rate target changes. Copyright 1998 by University of Chicago Press.

https://www.jstor.org/stable/10.1086/209741

Monetary Policy Actions, Intervention, and Exchange Rates: A Reexamination of the Empirical Relationships Using Federal Funds Rate Target Data

In the last two decades, there has been a global sea change in the theory and practice of central banking. The currently dominant ‘best practice’ approach to central banking consists of the following: (1) central bank independence (2) a focus on inflation fighting (including adopting formal ‘inflation targeting’) and (3) the use of indirect methods of monetary policy (that is, short-term interest rates as opposed to direct methods such as credit ceilings). This paper argues that this neo-liberal approach to central banking is highly idiosyncratic in that, as a package, it is dramatically different from the historically dominant theory and practice of central banking, not only in the developing world, but, notably, in the now developed countries themselves. Throughout the early and recent history of central banking in the US, England, Europe, and elsewhere, financing governments, managing exchange rates, and supporting economic sectors by using ‘direct methods’ of intervention have been among the most important tasks of central banking and, indeed, in many cases, were among the reasons for their existence. The neo-liberal central bank policy package, then, is drastically out of step with the history and dominant practice of central banking throughout most of its history.

https://www.econstor.eu/bitstream/10419/63574/1/513074155.pdf

Central Banks as Agents of Economic Development

Financial reforms initiated in most transitional socialist economies do not yet adequately provide many of the financial services associated with market-oriented financial systems. Such services - mobilizing resources, selecting firms and allocating capital, monitoring firm managers, and facilitating the management of transactions and risk - are a necessary condition for economic reform to improve living standards. This article envisages four central strategies to guide reforms of the financial sector: (a) building an infrastructure based on clear and enforceable property rights, modern accounting and auditing standards, reliable payments systems, sound prudential and enforcement regulations, and professionals trained in finance; (b) ending the shell game of trying to hide the losses of state-owned enterprises, and separating government decisions to finance priority firms from the allocation decisions of independent financial institutions; (c) privatizing some financial institutions early - although not necessarily precipitously - in concert with the privatization of firms and supervisory capabilities, meanwhile cleaning up bank loans to maximize the changes that firms and banks will succeed as private entities; and (d) improving the tax system and stressing a prudent interest rate policy to reduce uncertainty, distortions, and excessive repression of the financial sector.

Reforming finance in transitional socialist economies

Rapid structural change and widespread adoption of financial sector reforms in developing countries have placed pressure on traditional instruments of monetary control. It is widely accepted that, if the necessary macroeconomic control can be maintained, a move to an indirect, market-oriented system of monetary policy instruments will help the financial sector perform in a sounder and more efficient manner, resulting in the maximum contribution to economic development. With these developments in mind, the Financial Policy and Systems Division of the World Bank organized a seminar in May, 1990, which brought together experts from industrial and middle income countries, together with some of the Bank's own financial sector specialists and those of the International Monetary Fund, to discuss the lessons of recent experience with indirect methods of monetary control. This volume reports the edited proceedings of the seminar and will be of value to policy makers and students of developing countries.

Caprio, Gerard Jr. Honohan, Patrick

Papers

Monetary policy instruments for developing countries