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

The monetary policy (MP) targets the short end of the yield curve (YC) although real economic activity is dependent upon the medium to long-term market interest rates. Conventional wisdom is that decrease in the MP 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 does the MP translate across the YC remains at the forefront of many recent policy debates. Bringing the foundations of expectation hypothesis and empirical analysis of Sri Lanka market interest rates for the period 2000–2009 explains that MP impact monotonically decreases over the YC at the short end and become segmented towards long term of the YC. The impact appears to be weaker and increasingly segmented at times of financial and economic uncertainties. This invites policy attention on the part of MP effectiveness, structural impediments and market confidence in Sri Lanka.