This post in pdf FedFunds&Euro Area-Sept-16-2013
The Fed’s meeting on 17 and 18 September has been much discussed because of the announcement Ben Bernanke could do on financial assets purchases. I will not discuss this issue here.
What interests me is the first chart below, which shows the evolution of the two-year interest rate in one year. It reflects, via short bond yields, an anticipation of monetary policy by investors.
Since last May after Ben Bernanke’s testimony at the Congress the U.S. curve rises. This makes sense because it reflects the anticipation of a more stringent policy in the future. If indeed the U.S. central bank exits from its highly accommodative policy this will go through higher short-term interest rate that will push long-term interest rates higher*
But why is the Eurozone curve following the same path? We observed a similar profile for both curves even if the levels are different. The extent of upward movement is close for the two curves.
Since July 4, Mario Draghi said the euro zone interest rates would remain low for an extended period (“The Governing Council Expects the key ECB interest rates to remain at present levels or lower for an extended period of time” press conference on 4 July (here at the end of the second paragraph)). In view of the curve of the Euro zone, this statement by Mario Draghi did not have a lasting impact.
In other words, investors’ expectations suggest that if the Fed gets tough in its monetary policy stance then the Eurozone will soon do the same.
Therefore during his press conference Bernanke will need to be convincing on its commitment and on Fed’s commitment to maintain low-interest rates for a very long time. It’s a way to limit the risk of higher interest rates in Europe. If he is not seen as credible, expectations of a rise in U.S. interest rates could increase and eventually weigh heavily and permanently on interest rates in the Euro zone.
The second graph below shows the rate of futures for the fed funds rate (this reflects how fed funds rate are expected at various dates in the future (here I took on May 21 just before Bernanke’s statement to the Congress and September the 16 (last data). Between these two dates we see the strong change in how the future is expected)).
Ben Bernanke’s will need all his credibility to convince investors that he will maintain Fed’s interest rates at a very low-level for an extended period. This would help to flatten the fed funds’ futures curve in order to limit the risk of higher interest rates in the US and by contagion in the Euro Area.
For European countries, this situation also advocates to become more autonomous in the growth process in order to gain degrees of freedom and reduce this dependence. But this is the role of governments’ economic policies not of monetary policy.
Chart 1 – Monetary Policy Expectations
Chart 2 Fed Funds rate and Futures
* We can easily understand this issue in a two period economy. Suppose R is the long-term interest rate (two periods) and r the short-term interest rate (one period).
Then at equilibrium (1+R)² = (1+r)(1+r*)
Where r* is the expectation of the short-term interest rate for the second period. The higher r* the higher R for a given r