A MODEL OF TARGET CHANGES AND THE TERM STRUCTURE OF INTEREST-RATES

We investigate the effects of short-term rate targeting by the Federal Reserve on the term structure of interest rates, and make contributio ns at two levels. Using a new series of interest rate targets made ava ilable by the Federal Reserve Bank of New York, we develop a family of models that highlight the implications of discrete changes in interes t rate targets for the term structure of interest rates. We show that spreads between short-term rates and the overnight federal reserve fun ds rate are mainly driven by expectations of changes in the target, no t by the transitory dynamics of the overnight rate around the target. Hence, the bias in tests of the expectations hypothesis that we docume nt can be mainly attributed to the erroneous anticipation of future ch anges in monetary policy. Our modeling assumptions and newly-available data make it possible to extract a series of market expectations of t he next target change, which are compared with a series of realized ta rget changes.