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 contributions at two levels. Using a new series of interest rate targets made available by the Federal Reserve Bank of New York, we develop a family of models that highlight the implications of discrete changes in interest rate targets for the term structure of interest rates. We show that spreads between short-term rates and the overnight federal reserve funds rate are mainly driven by expectations of changes in the target, not by the transitory dynamics of the overnight rate around the target. Hence, the bias in tests of the expectations hypothesis that we document can be mainly attributed to the erroneous anticipation of future changes in monetary policy. Our modeling assumptions and newly-available data make it possible to extract a series of market expectations of the next target change, which are compared with a series of realized target changes.