By Brai Odion-Esene

WASHINGTON (MNI) – 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.

** MNI Washington Bureau: 202-371-2121 **

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