Economics, Econometrics and Finance
4 years ago

Federal Reserve's Rate Changes Cause Market Predictability to Break Down

Computing in Economics and Finance
Fed Funds Rate Targeting, Monetary Regimes and the Term Structure of Interbank Rates: Explaining the Predictability Smile
Vassil A. Konstantinov

Paper Summary

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The article presents a model of interest rates that includes rare jumps in short-term rates, controlled by a hidden process. This model is applied to the Federal Reserve's targeting process, with jumps representing changes in the fed funds target. By analyzing historical data, the model accurately reflects past monetary policy decisions. The model also shows that term premia change over time due to economic cycles, leading to deviations from the expectations hypothesis of interest rates. This results in a pattern known as the predictability smile in yield spread regressions.