Monetary Policy Uncertainty and the Response of the Yield Curve to Policy Shocks

• Published date: 01 June 2020
• Author: PETER TILLMANN
• Date: 01 June 2020
• DOI: http://doi.org/10.1111/jmcb.12657

DOI: 10.1111/jmcb.12657

PETER TILLMANN

Monetary Policy Uncertainty and the Response of

the Yield Curve to Policy Shocks

This paper studies the nonlinear response of the term structure of interest

rates to monetary policy shocks and presents a new stylized fact. Weshow

that uncertainty about monetary policy changes the way the term structure

responds to monetary policy. A policy tightening leads to a significantly

smaller increase in long-term bond yields if policy uncertainty is high at the

time of the shock. We also look at the decomposition of bond yields into

expectationsabout future policy and the term premium. The weaker response

of yields is driven by the fall in term premia, which fall more strongly if

uncertainty about policy is high. Conditional on a monetary policy shock,

higher uncertainty about monetary policy tends to make securities with

longer maturities relatively more attractive to investors.As a consequence,

investors demand even lowerterm premia. These findings are robust to the

measurement of monetary policy uncertainty,the definition of the monetary

policy shock, and to changing the model specification.

JEL codes: E43, E58, G12

Keywords: monetary policy uncertainty, term structure, term premium,

unconventional monetary policy, local projections.

THE TERM STRUCTURE OF INTEREST rates, that is, the range of

bond yields across the maturity spectrum, is closely tracked by central bankers and

market participants. The reason for this is twofold. First, long-term interest rates

should contain information about the public’s expectations about future monetary

policy. Central banks use the term structure to study the stance of monetary pol-

icy perceived by markets. Second, the term structure itself can be a policy target.

I thank Jens Christensen, Richard Crump, Peter H¨

ordahl, Klodiana Istrefi, and Eric Swanson for provid-

ing their data series. The editor of this journal, two anonymous referees, David Finck, FabienLabondance,

Matthias Neuenkirch, Bo Sun as well as seminar participants at CEF (Milan 2018), the GdRE meeting on

Money, Banking and Finance (Aix en Provence, 2018), DIW Berlin, the Workshop on Empirical Mone-

tary Economics (Paris, 2017), the KOF-ETH-UZH seminar on International Economic Policy, the 2017

Sheffield Workshopin Macroeconomics, and the University of Giessen provided important comments.

PETER TILLMANN is at Justus-Liebig-University Giessen (E-mail: peter.tillmann@wirtschaft.uni-

giessen.de).

Received June 26, 2017; and accepted in revised form February 18, 2019.

Journal of Money, Credit and Banking, Vol.52, No. 4 (June 2020)

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2019 The Ohio State University

804 :MONEY,CREDIT AND BANKING

Unconventional monetary policies such as forward guidance and asset purchases,

which the Federal Reserve (Fed) implemented after the financial crisis, were de-

signed to reduce long-term interest rates and, hence, to flatten the yield curve at the

zero lower bound. The latter dimension implies that monetary policy can, to some

extent, affect nominal interest rates for longer maturities. This paper studies the Fed’s

ability to steer bond yields if the public is uncertain about the future direction of

monetary policy.

It is well established that monetary policy can move bond yields (Evans and

Marshall 1998, Cochrane and Piazzesi 2002). In fact, the effect of monetary policy

on longer term yields is at the core of the monetary transmission mechanism. However,

researchers derivethis finding using linear regression models for large samples of time

series without allowing for the connection between policy shocks and bond yields to

vary over time.1Here, we study a specific source of nonlinearity: the changing degree

of uncertainty about future monetary policy. Even though monetary policy is now

better communicated and more predictable than in the past, policy anticipation is less

than perfect. This gives rise to a considerable degree of monetary policy uncertainty.

Empirical evidence suggests that the degree of uncertainty about monetary policy

can be large and volatile (see, among others, Husted, Rogers, and Sun 2016). This

motivates us to analyze whether monetary policy is less effective in driving bond

yields if households and market participants have doubts about monetary policy in

the future, which are incorporated in long-term yields.

In this paper, we provide new stylized facts on the response of the yield curve to

monetary policy. We proceed as follows. First, we use data on fitted yields on U.S.

governments’ bonds and estimates of expectations component, respectively, from

Adrian, Crump, and Moench (2013a), Kim and Wright (2005), and Christensen and

Rudebusch (2016). The latter data set takes account of the asymmetric behavior of

yields at the zero lower bound. We relate yields on bond of different maturities, the

expectations component, and the term premium to a monetary policy shock. The

monetary policy shock is derived from asset-price responses on Federal Open Market

Committee (FOMC) meeting days.

A series of local projections (Jord`

a 2005) generates impulse response functions

following a monetary policy shock. They showthat bond yields increase after a policy

tightening and term premia fall. Let us for a moment set aside the interpretation of

the latter finding.

Second, we use several measures of monetary policy uncertainty,which are news-

based, market-based, or survey-based. Among them are the narrative index provided

by Husted, Rogers, and Sun (2016), a measure based on forecasts derivedby Istrefi and

Muabbi (2018) and the variance of monetary policy surprises. In a separate exercise,

we use a measure of disagreement about future monetary policy,that is, the dispersion

of T-bill forecasts. These uncertainty measures are used to condition the impulse

response of the term structure variables to a monetary policyshock on monetary policy

1. Swanson(2017) and Inoue and Rossi (2017) allow for the effects of conventional and unconventional

monetary policy shocks on yields to vary over time.