From October 1993 to June 1994, long-term interest rates in the United States rose by about 1 1/2 percentage points, substantially more than the increase in short-term rates and despite the relatively stable inflation during this period. The purpose of this paper is to assess the quantitative importance of various explanations for the increase in long-term rates and to investigate whether this increase can be explained using standard models of the term structure of interest rates.
This study finds evidence that the estimated coefficients from a standard term structure equation--that models the long rate as a function of a long distributed lag on realized short-term rates--may have changed substantially since the early 1980s. Further, this equation performs poorly after 1993, apparently because it is unable to capture adequately the important role of expectations regarding current and prospective monetary policy in determining the level of long-term interest rates.
The responsiveness of the long-term rate to monetary policy appears to have increased since the early 1980s. This is illustrated by comparing changes in long- and short-term rates during periods of monetary policy tightening. In addition, it is shown that the estimated coefficient from a simple regression of the change in the long-term rate on the change in the federal funds rate has more than doubled since 1989.
The standard term structure equation is then augmented by the addition of variables that proxy for the stance of monetary policy and that attempt to control for the effects of portfolio shifts. The augmented equation tracks variations in the long-term rate significantly better than the traditional term structure equation. However, the augmented specification also shows signs of a structural break in the 1980s. The coefficients on the monetary policy, economic activity, and portfolio shift variables increase in absolute magnitude when the equation is estimated over the 1984-94 period. Thus, an important finding of this paper is that the sensitivity of long-term interest rates to changes in current and prospective monetary policy has increased significantly since the early 1980s.