It is widely held that the central bank is a key factor in the determination of interest rates. By popular thinking, the Fed influences the short-term interest rates by influencing monetary liquidity in the markets. Through the injection of liquidity, the Fed pushes short-term interest rates lower. Conversely, by withdrawing liquidity, the Fed exerts an upward pressure on the short-term interest rates. Popular thinking also suggests that long-term rates are the average of current and expected short-term interest rates. If today’s one-year rate is 4 percent and the next year’s one-year rate is expected to be 5 percent, then the two-year rate today should be 4.5 percent ((4 + 5)/2 = 4.5%). Conversely, if today’s one-year rate is 4 percent and the next year’s one-year rate is expected to be 3%, then the two-year rate today should be 3.5 percent (4 + 3)/2 = 3.5%. Hence, it would appear that the central bank is the key in the interest rate determination process. However, is this the case?
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