Expect a gradual return to interest-rate normalization.
by. Steve Rick
The new Federal Reserve Chair Janet Yellen was bound to change how the Fed communicates its current and future monetary policy when she took over the reins from Ben Bernanke.
The March 19 Federal Open Market Committee meeting, the first Yellen chaired, gave market participants much to digest regarding the future of interest rates.
The first change was in regard to the agency’s forward rate guidance. This is the notion that the Fed can affect interest rates today by making assurances about how they will conduct policy tomorrow.
The Fed, for example, can influence today’s 10-year Treasury interest rate by committing to keep short-term interest rates low for the next couple of years. This is known as the Expectations Theory of Interest Rates, which states that today’s long-term interest rates are the average of expected future short term interest rates over the life of the debt instrument.
Because long-term debt is not a perfect substitute for shortterm debt—investors typically are risk-averse and prefer short-term debt—economists also add a “term premium” to the average of expected future short-term interest rates when evaluating long-term rates.continue reading »