The excess sensitivity of long-term interest rates and central bank credibility

Abstract

Long-term interest rates show considerable reaction to macroeconomic shocks and news. This is, however, difficult to explain using standard rational expectations macro-finance models, as are widely used in policy analyses. In this research, we demonstrate that concerns regarding central bank credibility can account for the excess sensitivity of long-term interest rates, using an estimated macro-finance model that incorporates endogenously evolving perceptions about central bank credibility. In particular, long-term interest rates respond more strongly to macro shocks when credibility is lower. Quantitatively, two thirds of the observed decline in the volatility of U.S. long-term rates after the mid-1990s can be attributed to an increase of credibility in the Fed.