Explaining rotated linkages between monetary policy and long-term interest rates

Abhishek Rohit and Raghavendra S. Bhat

Applied Economics, 2023, vol. 55, issue 25, 2835-2846

Abstract: Understanding the linkages between monetary policy surprises and long-term interest rates is of immense interest to policymakers and researchers worldwide. In this paper, we investigate this relationship for a large sample of 29 economies and attempt to unravel the possible reasons for rotated linkages between these two variables in a long time-period, i.e., 1979–2019. We provide empirical evidence on exogenous shifts in the preferences of central banks in terms of weightage of inflation to output, altering the behaviour of long-term interest rates. We examine this phenomenon using financial crisis, and positive inflation deviations which may cause such exogenous shifts, and find both to be responsible for rotated linkages. On comparison, we find that the linkages get rotated the most during systemic crisis, followed by banking crisis, and currency crisis in that order. In terms of policy prescriptions, we confirm that central banks can ensure effective monetary transmission to long-term interest rates by having a robust monetary policy framework which encompasses the three pillars of independence and accountability, policy and operational strategy, and communications.

Date: 2023
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DOI: 10.1080/00036846.2022.2107164

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