Expectations play key role in policy transmission – BoE paper

Interest rate expectations and term premia are equally important to the transmission of monetary policy to the yield curve, research published by the Bank of England finds.

Iryna Kaminska, Haroon Mumtaz and Roman Sustek note earlier research found only a “miniscule role” for interest rate expectations, with most of the effect occurring through term premia. This is a problem, as expectations typically play a large role in central bank models, the authors note.

In the working paper, they use high-frequency data on the US to isolate the effects of monetary policy surprises from other news that might affect the yield curve. They then use an affine term structure model to decompose movements in yields into expectations and term premia.

“We find that once the small sample bias is accounted for, the reaction of expected interest rates to policy surprises is as large as that of term premia,” the authors say.

The authors focus on the “conventional” monetary policy employed in the decade up until the 2008 financial crisis. They note the analysis could be extended to the more recent period. But the presence of the effective lower bound on rates would require the term structure model to depart from the “convenient affine representation”, they say.