The Conventional Monetary Policy And Term Structure Of Interest Rates During The Financial Crisis

There is a growing literature on whether the unconventional policies of the Fed during the financial crisis have been effective. However, the literature is relatively silent on the effectiveness of conventional monetary policies during the financial crisis, a rather surprising fact given that conventional policies were the Fed’s initial response to the financial crisis. This is a nontrivial question due to problems associated with the existing methods of identifying conventional monetary policy shocks in the context of the financial crisis. In this perspective, our paper analyzes the effectiveness of conventional monetary policy in changing the term structure of interest rates during the financial crisis. Our identification strategy based on the conditional heteroskedasticity of the structural innovations allows us to specify flexible structural vector autoregressive (SVAR) processes that do not suffer from the problems associated with existing methods. Comparing results based on sample periods excluding and including the financial crisis, we find that conventional monetary policy as measured in our SVAR has lost its effectiveness in changing the term structure of interest rates during the financial crisis. This result suggests that the Fed’s use of unconventional policies, at least, with the objective of changing the term structure of interest rates was appropriate.