Interest rates which determine savings and investment decisions and therefore have a stronger impact on the economy typically have longer maturities. In order to impact the economy, monetary policy impulses must therefore first be transmitted from the money market to the capital market. The money market and the capital market are linked by expectations. Neglecting transaction costs and risk premiums, the expectations theory of the term structure views the long-term interest rate as an average of the shortterm interest rates expected to prevail until the maturity of the respective bond. Although current shortterm interest rates have some effect on longer-term bond yields, the expectations theory of the term structure tells us that it is primarily expected future short-term interest rates which determine bond yields. In practice, due to uncertainty about the future evolution of short-term interest rates and due to time-varying risk premiums, the longer the maturity, the weaker the link between current short-term rates and long-term rates. Therefore, in practice, a central bank would often find it difficult to guide longer-term interest rates to a level commensurate with what it considers to be the optimal monetary policy stance. Assuming a flexible exchange rate regime, the exchange rate is arguably the quickest transmission channel for monetary policy, particularly in open economies. Exchange rate movements rapidly affect prices (via import prices) and subsequently demand (by boosting imports and slowing down exports, or vice versa). In theory, monetary policy impacts exchange rates via the yield curve and from there via interest rate parity relations.
My point of departure will be the monetary policy instrument, which is typically a short-term interest rate. In light of the close links between monetary policy and financial markets, I will then explain the benefits of central bank transparency. My comments will end with a note of caution concerning the information value of financial market prices in a world of increasingly market oriented and transparent central banks. 1. How does monetary policy affect financial markets? Monetary policy is aimed at preserving price stability. In some countries, central banks operate under mandates that refer to additional objectives such as full employment, maximum sustainable growth, stable interest rates or stable exchange rates. To meet their objectives, central banks intervene in financial markets. It is through the financial markets that monetary policy affects the real economy. In other words, financial markets are the connecting link in the transmission mechanism between monetary policy and the real economy. I will focus on the first part of the transmission mechanism only, i.e. the transmission from the monetary policy instrument to financial markets. Monetary policy affects financial markets through various channels. However, the transmission process from monetary policy to financial markets and finally to the real economy has a single source: the monetary policy instrument. Typically, the monetary policy instrument is a financial market price which is directly set or closely controlled by the central bank. For most central banks with floating exchange rates today, the monetary policy instrument is a short-term interest rate.