The expectations channel and monetary policy operations in Asia-Pacific bond markets Eli M Remolona Head of Economics for Asia and the Pacific Workshop on Developing Government Bond Markets: Challenges towards Sound Monetary Management Bali, 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 target Market for operations AustraliaCash rate (overnight)Repo IndiaRepo (overnight)Repo IndonesiaOne-month SBISBI auction JapanOvernight call rateRepo KoreaOvernight call rateMSB/repo MalaysiaOvernight policy rateTender/repo New ZealandOfficial cash rateFX swaps PhilippinesOvernight repoRepo ThailandOne-day repoRepo

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 Dealer 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 announcementPrice impact Non-farm payroll23.1* 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 rate4.6 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