When the Fed or a central bank changes interest rates, this impacts short-term rates first and foremost. But why is it that short-term interests are impacted as opposed to short- AND long-term, or just long-term interest rates? And is this all intentional?
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2 Answers
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Central banks do try to impact long term interest rates. Since 2008 many CB's implemented various policies that were meant to affect entire yield curve (see BoJ). That was the intention behind excessive use of forward guidance (see The Oxford Handbook of the Economics of Central Banking).
However, while there is evidence that central banks can affect long term yields by setting expectations (see Hansen et al 2019), there is very little evidence to show that central banks can actually successfully conduct policy that way. For example, the US and EU forward guidance ended in debacle since both ECB and Fed had to break their own Odyssean forward guidance due to high inflation. Moreover, they failed at their goal which was to increase long term rates but not as much as they did. So there is very little evidence to suggest that this can be done successfully with the current level of understanding of these tools.
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$\begingroup$ Hi @1muffon1. Could you add more on 'why' if possible, please? $\endgroup$– EB3112Oct 19, 2022 at 22:30
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1$\begingroup$ @EB3112 but the answer is that they are already doing it so asking why they are not doing it is non sequitur. For example, if someone asks you why person x is not jumping but the person x is actually objectively jumping then question why person x is non jumping becomes irrelevant, answer is that the person is jumping $\endgroup$– 1muflon1 ♦Oct 20, 2022 at 0:47
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$\begingroup$ @1muffon1. I disagree. 'why' is a legitimate question if the motivations for conventional + unconventional monetary policy are not fully understood. $\endgroup$– EB3112Oct 20, 2022 at 6:54
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1$\begingroup$ @EB3112 why they are doing it would be legitimate question, how can question why they are not doing it if they are already doing it valid question, again how do you answer question why person x does not jump if person x does jump? $\endgroup$– 1muflon1 ♦Oct 20, 2022 at 7:28
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$\begingroup$ @1muffon1. I feel we're speaking across each other, apologies. I think the problem relates to nuances between the OP's title question, and the thread question. I feel we're in disagreement because they'e two different questions. $\endgroup$– EB3112Oct 20, 2022 at 12:59
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It is crucial to understand that interest rates along the curve (i.e., short and long term) are all set in the open market: interest rate for, say 10 year, is basically the yield for a government bond security for that maturity of 10 years.
For this reason, unless the CBs are heavily intervening at the open market (which this operation might have some unintended and to a certain extent unpredictable consequences) they have no control (rather than impact) on the interest rate all along the curve. That said, with sufficient buying/selling of governments bonds the CB can directly control the interest rates. We see example for such intervention in the Bank of Japan.
Basically, CBs have control of the intraday interest rate: the interest rate of loans between the banks. (Actually, even there this is not direct control, hence the Fed for example speaks of "target fed funds rate" in range).
So, in theory, the interest rates even in the short term (for, say, 1 year) are free from this target intraday rate set by the CB. In practice, however, the short term rates are highly impacted by the CB target rates because of the action of the participates in the open market. Let's have a look at this example:
Say, a 1-year bond is traded in yield of 1%; the next day, the CB announces the target rate of 3% from 1% (extreme for the sake of the example). What will the market participates do in this case? They figure out they could get 3% intraday and also believe that interest rate will be at least above 2% throughout the year (they think this because of either direct guidance of the CB, or by history that the CB does not usually change interests rates so fast); so they will untimely sell the bond in favor of the intraday rates (or shorter term bond). This selling of the 1-year triggers increased yield.
But, if the market participants hold a 10-year bond with yield of 2%, would they be lured the sell it? to a certain extent: yes - with the same reasoning of the 1-year note. But in terms of volume they will much less tempted to sell. This is because they have no assurance that in even only 2 years time from the now, the CB will keep its 3% rate, they might believe the interest rate will ultimately return to its "normal/average" level of 1%; also they have the risk that the CB target rate would drop to 0% in 5 year from now and will stays there for long.
In short, the high certainty in target rate is limited only for months or 1-2 years, hence for the long term bond say of 10 or 20 years this is a relatively short time hence it should in theory be impacted much less by short term target rates changes.
Now, as for the question in title (which I see as a different question frpm the question in the body of the post). It is true that most CBs prefer not the meddle in the open market with the objective to setting rates. One possible reason for this is that this kind of operation changes the monetary base and ultimately effects the money supply in a less predictable manner because we don't know how much we need to buy/sell in the open market.
