Interest Rates
Interest rates have frequently been proposed as a guide to policy, not only
because of the role they play in a wide variety of spending decisions but also
because information on interest rates is available on a real time basis. Arguing
against giving interest rates the primary role in guiding monetary policy is
uncertainty about exactly what level or path of interest rates is consistent
with the basic goals of monetary policy. The appropriate level of interest rates
will vary with the stance of fiscal policy, changes in the pattern of household
and business spending, productivity growth, and economic developments abroad. It
can be difficult not only to gauge the strength of these forces but also to
translate them into a path for interest rates.
The difference
between the interest rate on longer term and shorter term instruments has also
been suggested as a guide to monetary policy. Whereas short-term interest rates
are strongly influenced by the current setting of the policy instrument,
longer term interest rates are influenced by expectations of future short term
interest rates and thus by the longer term effects of monetary policy on
inflation and output. For example, longer term interest rates far above
short term rates may be a signal that participants in the bond market believe
that monetary policy has become too expansive and thus, without a monetary
policy correction, more inflationary. Conversely, short term rates above longer
rates may be an indication that policy is too restrictive, perhaps risking an
unwanted loss of output and employment. Other factors include prospective fiscal
policy, developments in foreign exchange markets, and expectations about the
future path of monetary policy.
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