Monetary policy along the yield curve: why can central banks affect long-term real rates?

Summary

Focus

Long-term real interest rates are typically thought to be determined by real factors like productivity growth, demographics, income inequality and shifts in the demand and supply of safe assets. However, long-term real rates seem to be very sensitive to changes in central bank policy rates. Conventional New Keynesian economic models suggest this should not happen, as setting the policy rate away from the natural rate (r*) for a prolonged period would significantly affect current economic activity and, therefore, inflation. 

Contribution

We develop a Finitely-Lived Agent New Keynesian (FLANK) model, which integrates lifecycle dynamics into the analysis of monetary policy. The model identifies three ways that changes in future real interest rates affect consumption: intertemporal substitution (choosing when to spend money), changes in asset values and the desire to save for retirement (which depends on how much interest income people expect to earn). These channels can offset each other, so persistent interest rate changes might have little impact on economic activity and inflation.

Findings

When persistent interest rate changes have a limited impact on inflation, central banks may not need to know the exact r* to effectively implement monetary policy. The economy becomes very "forgiving" to a central bank that misperceives r*, without major disruption. This view challenges traditional perspectives and suggests that central banks might be inadvertently influencing long-term real rates through their policy decisions.

Abstract

This paper presents theory and evidence to advance the notion that very persistent policy-induced interest rate changes may have only weak effects on activity. This arises when consumption-savings decisions are not primarily driven by intertemporal substitution, but also by life-cycle forces. The small impact of persistent rate changes results when intertemporal substitution and asset valuation effects are offset by interest income effects, which affect asset demand. In our framework, knowing the exact location of r* becomes less critical to central banks, as interest rates can be kept away from this level for prolonged periods of time, allowing monetary policy to unconsciously drive trends in real rates. This perspective offers an explanation to a set of puzzles, including why long-term real rates often move quite closely with short-term policy rates.

JEL classification: E21, E43, E44, E52, G51

Keywords: monetary policy, r-star, monetary transmission mechanism, retirement savings, unconventional monetary policy