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The New York Innovation Center bridges the worlds of finance, technology, and innovation and generates insights into high-value central bank-related opportunities.
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| October 1995 Number 9523 |
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Authors: Eli M. Remolona, Joseph Dziwura, and Irene Pedraza How is the term structure able to predict future interest rates several months in the future and why is it so steep at the short end? Recent empirical work shows that rates of mean reversion are too slow to help predict short rates or to account for the curve's steepness. We propose that short term interest rates are predictable because Federal Reserve actions are predictable. In particular, our estimates suggest that the market anticipates the Fed's monetary stance twelve months in advance. Moreover, forward rates contain more information when the Fed is expected to tighten than when it is expected to ease. When the market anticipates a tightening, expectations about rising short rates drive movements in near term forward rates. When the market anticipates an easing, the term premia drives movements in forward curves. This asymmetry in the behavior of forward rates with regard to future monetary policy stance explains the forward curve's typically humped shape. We argue that a rapid convergence to a Fed target when a tightening is anticipated but not when an easing is anticipated generates an average forward curve that is steep at the short end. |
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38 pages / 1,389 kb
