A Model of Target Changes and the Term Structure of Interest Rates

Abstract

We explore the effects of overnight-rate targeting on nominal interest rates of longer maturities. In a realistic model of noisy targeting and infrequent target changes, expectations of future policy actions introduce persistent spreads between interest rates of different maturities. Some empirical features of U.S. money-market daily interest rate data are broadly consistent with our theoretical assumptions and results. Not surprisingly, however, the data reject the expectations-hypothesis (EH) relation that we take as a working assumptions. A newly available series of historical interest-rate targets and simple tests based on our theoretical insights suggest that the EH rejection may be due to erroneous market expectations of the policy-induced component of fed funds dynamics. We briefly discuss how the size and volatility of such expectations may be interpreted from the perspective of our theoretical framework.