Are Fiscal and Monetary Policies Reflected in Real Yields? Evidence from a Period of Disinflation and Declining Deficit Targets

Abstract

We examine the effect of monetary and  scal policies on yields on shortand long-term indexed bonds, in view of the crucial importance of these yields for economic activity. We extend the current literature dealing with the same question by providing evidence about a period in which the government adopted declining in ation and  scal targets. In such cases the policy shift could be perceived as having implications in the long run and therefore may effect long-term as well as short–term yields. The fact that most government bonds in Israel are CPI-indexed allows us to use the real yields for the various terms directly, without having to decompose nominal yields into a real component and in ation expectations, as is the case with the data for other countries. Our main  nding is that  scal and monetary policies do affect short– and long-term yields. We  nd that a rise of one percent in the expected de cit/GDP ratio (cyclically adjusted) increases the long-term interest rate by 0.2 percentage points, i.e., Ricardian equivalence does not obtain fully. Another  nding is that  scal policy has a slightly greater effect on long-term yields than on medium- and short-term yields. In addition, changes in the government’s de cit targets affect long–term yields. With regard to the effect of monetary policy, the longer the term of bonds, the weaker is the effect on yields, although the effect on long-term yields is by no means inconsiderable. A one-percentage-point rise in the central bank’s key interest rate (in real terms) serves to increase the yield on one-year bonds by 0.8 percentage points, and the yield on 10-year bonds by 0.3 percentage points. Part of the signi cant long-term in uence of monetary policy stems from its direct effect on the long-term component of yields—which we isolate in this study (the forward component). Our results are best interpreted as evidence for a long-term effect of monetary policy during a (credible) disin ation process. We also  nd that in the wake of  nancial liberalization and the greater openness of the economy, the US interest rate has come to affect the yields on domestic bonds, albeit less signi cantly than expected in a fully open economy.