The expectations channel and The expectations channel and mmonetary onetary policy operationspolicy operations inin Asia-Pacific bAsia-Pacific bond ond mmarketarketss

Eli Eli M RemolonaM RemolonaHead of Economics for Asia and the PacificHead of Economics for Asia and the Pacific

Workshop on Developing Government Bond Workshop on Developing Government Bond Markets: Challenges towards Sound Monetary Markets: Challenges towards Sound Monetary Management Management Bali, October 31 - November 1, 2007Bali, October 31 - November 1, 2007

Informational underpinnings of government bond markets

A two-way street: central banks and bond markets can help each other

Liquid government bond markets need information about monetary policy

Expectations channel relies on bond markets

Information in deeds: monetary operations in Asia and the Pacific

Choice of operational policy target

Operational adjustment of target

Information in data and words: the US experience

Implications of transparency in bond market

Implications of expectations management

Mechanics of expectations channel

Operational policy target is short rate – “an interest rate that is relevant to virtually no economically interesting transactions” – Blinder (2006)

Effect is through longer maturities in yield curve

Investors make guesses about future policy rates

Yield curves embody these expectations as well as uncertainty surrounding them

Why not target long rate?

May be way to avoid liquidity trap

But forecastable change in target implies large spikes in short rates on day of target change – Woodford (2005)

Information to build yield curve

Gradualism and reversal aversion

Data and words to manage expectations

Policy rate targets and markets for operations in Asia and the Pacific

Policy rate targetMarket for operations

Australia Cash rate (overnight) Repo

India Repo (overnight) Repo

Indonesia One-month SBI SBI auction

Japan Overnight call rate Repo

Korea Overnight call rate MSB/repo

Malaysia Overnight policy rate Tender/repo

New Zealand Official cash rate FX swaps

Philippines Overnight repo Repo

Thailand One-day repo Repo

Gradualism and reversion aversion in Asia and the Pacific

Policy rate expectations in yield curves

A deep and liquid bond market:the US Treasury market

Broker DealerDealer

Customers Customers

Interdealer market

How primary dealers provide liquidity

As market makers, they must bid at auctions and provide two-way quotes in secondary market

Unlike in equity market, interdealer market is “informed trading with informed”

To provide liquidity, dealers need informational advantage

Before 1994, trading with New York Fed gave them information about monetary stance

With Fed transparency dealers now make it their business to be well informed about macro developments and how FOMC reads data

They use informational advantage to take large positions in market

Price and trading action when information arrives: the 5-year US Treasury note on employment report day

Price impact of announcement surprises:the 5-year US Treasury note(Fleming and Remolona, JPM 1999)

US announcement Price impact

Non-farm payroll 23.1*

PPI 8.6*

Ten-year note auction 8.0*

30-year bond auction 7.7*

CPI 6.5*

New home sales 5.1*

Fed funds target rate 4.6

Transparency index = 1 – 4.6/23.1 = 0.80

The term structure of announcement effects: the US non-farm payroll announcement

Action is in intermediates -- as market makes guess about policy rate several meetings away

Conclusions

For central banks in Asia and Pacific, monetary policy operations consistent with expectations channel

Policy rate target is short rate

Gradualism and reversal aversion

Expectations reflected in yield curves

In US experience, liquid bond market is one where

Primary dealers provide liquidity when kept well informed about monetary policy

With transparency, yield curves react more to macro news than to policy rate changes

With expectations management, at times of information arrival, action is in intermediate maturities

Thank you!

References

Blinder (2006) “Monetary policy today: sixteen questions and about twelve answers,” paper presented at the Banco de Espana.Fleming and Remolona (1999) “Price formation and liquidity in the US Treasury market: the response to public information,” Journal of Finance (October).Fleming and Remolona (1999) “What moves the bond market,” Journal of Portfolio Management (Summer).Fleming and Remolona (1999) “The term structure of announcement effects,” BIS Working Paper No 71 (June).Ho (2007) “Implementing monetary policy in the 2000s: operating procedures in Asia and beyond,” draft, BIS.Woodford (2005) “Comment on ‘Using the long-term interest rate as a policy instrument’,” (April)Woodford (2005) “Central bank communication and policy effectiveness,” paper presented at Jackson Hole