29 III Articles ON THE TARGETING OF SHORT AND LONG TERM INTEREST RATES* Bernardino Adão** | Isabel Correia** | Pedro Teles** Abstract This article is a theoretical reappraisal of the infrequent policy of central banks in targeting interest rates at both short and longer maturities. 1. Introduction In 2009, the ECB conducted one week, three and six months, and one year, liquidity providing operations at fixed rates. Roughly at the same time, the Fed was pursuing its policies of massive purchases of longer term assets with the objective of lowering rates at those horizons. In September of 2011, the Board announced Operation Twist II, the first having been the controversial policies of the early sixties through which the Fed hoped to raise short rates and lower long rates. The objective of the 2011 policies, was rather to raise medium term rates in exchange for lower long term rates. Other evidence for the ability of a central bank to manipulate rates at different maturities is the US monetary policy of the forties, before the Fed-Treasury Accord in 1951. In order to help finance the war, the Fed agreed to establish a ceiling on the 12 month Treasury certificate, of 2.5%, while it was also targeting the rates on the 90 day Treasury bill at 0.375% annual. Not surprisingly, by 1947, the Fed was holding 97% of the outstanding T-bills. While there seems to be empirical evidence for the ability of a central bank to conduct operations at other than short run maturities 1 , a simple logic seems to fail, raising understandable concerns at operation departments in central banks: Aren’t there arbitrage conditions relating rates at different maturities? Under the expectation hypothesis, the long rates are simple averages of the shorter rates. If that is the case, then there are no degrees of freedom in controlling the long rates in addition to the short, as the historical partial failure in controlling rates seems to suggest. On the other hand, the also partial success in controlling those rates requires an explanation. This is what we do in this article, based on work by Adão, Correia and Teles (2010). Why is it important to understand this? Why shouldn’t central banks do business as usual, using short rates and letting the markets pick the long rates? The pressing reason is the zero bound constraint on interest rates. Since 2008, policy rates have been very close to zero in the US, UK, and the Euro area. They were also close to zero in the US in 2003 and 2004, when the policy rate fell down to 1%, and remained there for more than a year. Because people would otherwise hold money, interest rates cannot be lowered significantly below zero. How can then the central bank provide stimulus to a feeble economy? One possibility is to lower the long rates if those are above zero. 1 In remarks before the National Economists Club, in 2002, Ben Bernanke, states this: “Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities”. * The opinions expressed in the article are those of the authors and do not necessarily coincide with those of Banco de Portugal or the Eurosystem. Any errors and omissions are the sole responsibility of the authors. ** Banco de Portugal, Economics and Research Department.