Abstract
Previous studies attribute the failure of the expectations theory, using the 3–6-month Treasury bill spread, to the Federal Reserve’s commitment to stabilizing interest rates. We find that with the advent of Greenspan, this spread predicts future changes in the short rate in the USA. This success can be explained by interest rate smoothing and greater transparency by the Fed. By enhancing the management of market expectations and reducing uncertainty, the central bank improves interest rate predictability and gains credibility from the market, as lower term premia suggest.
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Notes
The start date is chosen to exclude the strict monetary targeting regime during Volcker’s tenure. Previous years were not included due to a lack of data availability.
We find the federal target rate to still be a random walk whose innovations, however, have changed, becoming more predictable. Note that, since the series is a random walk, the graphical representation of residuals from the regression of the target on a constant and its first lagged value would be almost indistinguishable from those in Fig. 1.
Results, omitted for brevity, are available from the author upon request.
This is the evocative title of William Greider’s (1987) bestseller about the Federal Reserve.
A Quandt–Andrews unknown breakpoint test finds the single breakpoint to be in 2004:3.
We do not report results for regressions with too few observations; hence, the last starting date considered is 2005:9.
Swanson (2006), analysing the same period, introduces a variable named “momentum” that signals uncertainty created by rapid changes in the Fed target rate; he finds that this variable spiked in 2001–2 and 1994–95. Even a Bai–Perron multiple breakpoint test finds the years 1994 and 2002 among the possible breakpoints. Results, not reported for brevity, are available from the author upon request.
According to Caporale and Caporale (2003), in the USA, the reduction in interest rate uncertainty brought about by the establishment of the Fed lowered financial market risk, causing a decrease in the risk premium a 6-month instrument pays over a 3-month one from 0.65 before the Fed founding to 0.3 for the period 1914–1933.
Bernanke (2004) stresses this point comparing monetary policy to driving a car whose speed “depends not on the pressure on the accelerator at that moment but rather on the expected average pressure on the accelerator over the rest of the trip.”
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Florio, A. Term structure and interest rate stabilization policies in the Greenspan era. Empir Econ 59, 345–355 (2020). https://doi.org/10.1007/s00181-019-01672-x
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DOI: https://doi.org/10.1007/s00181-019-01672-x