Monetary Policy and Yield Curve Dynamics in an Emerging Market: Sri Lankan Perspectives

The monetary policy targets the very short end of the yield curve although real economic activity is largely dependent upon the medium to long- term market interest rates. Conventional wisdom is that decrease in the monetary policy target rate leads to an immediate decrease in market interest rates, and an increase in bond prices; yet evidence for this view is elusive. Therefore, the question of how do the monetary policy actions translate across the yield curve remain at the forefront of many recent policy debates. Bringing the foundations of Expectation Hypothesis (EH) and empirical analysis of Sri Lanka money market and government bond daily yield rates for the period 2000 to 2009 through the application of Ordinary Least Squares (OLS) and Vector Error Correction Model (VECM), explains that monetary policy impact monotonically decreases over the yield curve at the short-end and become segmented toward medium to long-term of the yield curve. The impact appears to be waning at a faster pace at times of financial and economic uncertainties compared against stable economic period. This invites policy attention on the part of monetary policy effectiveness, structural impediments and market confidence in Sri Lanka.