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short essays and reports on the economic issues of the day
2005 ■ Number 21

The Monetary Policy Transmission Mechanism?
Daniel L. Thornton
espite the fact that the Federal Open Market
Committee (FOMC) has increased its target for the
federal funds rate by 25 basis points at each of its
previous ten meetings, and markets anticipate still further
increases, the 10-year Treasury yield has remained largely
unchanged. (See p. 9.) Chairman Greenspan recently suggested
that the behavior of long-term rates in the face of such changes
in the funds rate is “clearly without precedent in our recent
In his final speech before leaving the Fed, former Governor
Ben Bernanke gave an explanation for this “unprecedented”
experience. Specifically, Bernanke provides strong evidence
that “the relatively low level of long-term real interest rates in
the world today” is the result of structural change over the past
decade that “has created a significant increase in the global
supply of saving—a global saving glut.”2 One possible implication of Bernanke’s analysis is that domestic real long-term
interest rates are determined in a global market, whereas shortterm interest rates are determined in domestic markets by
monetary policy actions. If real long-term yields are determined
in the global market, the core real rate in each country would
be the same. Cross-country differences would be due to idiosyncratic risk factors. This possibility is supported by the fact
that the inflation index yields on long-term bonds in the
United States, France, and the United Kingdom have been
relatively close to each other and behaved similarly in recent
years. (See p. 11.)
The possibility that domestic real long-term interest rates
are segmented from domestic short-term rates has strong
implications for perhaps the most widely held theory of the
monetary policy transmission mechanism—the interest rate
channel of monetary policy.
The interest rate channel of monetary policy exists if monetary policy actions affect interest rates that cause individuals
and businesses to alter their spending decisions that, in turn,
bring about changes in output and prices. While consumption
accounts for more than two thirds of gross domestic product
(GDP), it is relatively stable over time and is thought to be
relatively insensitive to changes in interest rates. In contrast,
GDP’s most variable component, investment, is thought to be


more interest sensitive. Investment spending might be more
sensitive to long-term interest rates than to short-term rates,
such as the overnight federal funds rate, which the FOMC
targets. The crucial link between the federal funds rate and
the long-term rate is the expectations hypothesis (EH), which
states that at each point in time the long-term rate is equal to
the average of the short-term rate expected to prevail over the
maturity of the long-term asset plus a constant risk premium.
If the EH is correct, policymakers affect long-term rates by
changing current and expected future short-term rates. There
is virtually no empirical support for empirical implications of
the EH, however. The possibility that domestic real long-term
interest rates are segmented from domestic short-term rates
provides a new reason to question its validity and, consequently,
the interest rate channel of monetary policy.
If long-term real interest rates are determined in a global
market, the FOMC’s scope for affecting domestic real long-term
yields by adjusting its target for the federal funds rate may be
limited. It seems unlikely that changes in U.S. monetary policy would have no impact on conditions in the global market.
Nevertheless, to the extent that long-term rates are affected by
conditions other than the market’s expectation of short-term
interest rates, both the magnitude and timing of the effect of
FOMC actions on long-term rates would be limited—hence,
so would any impact that monetary policy has on inflation
and output through the adjustment of long-term interest rates.
Of course, if the Fed affects inflation and output mainly
through short-term interest rates, rather than long-term rates,
the FOMC’s ability to influence economic activity via the
interest rate channel would not be impaired. Finally, the possible segmentation of the long-term rate from the effect of
policy actions on the short-term rate may not impair the
FOMC’s effectiveness if monetary policy works through other
channels. ■

Greenspan, Alan. Monetary Policy Report to the Congress before the Committee
on Financial Services, U.S. House of Representatives, July 20, 2005;


Bernanke, Ben S. “The Global Saving Glut and the U.S. Current Account Deficit.”
Speech presented as the Sandridge Lecture, Richmond, Virginia, April 14, 2005;

Views expressed do not necessarily reflect official positions of the Federal Reserve System.