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Homework Assignment #4– Econ 351 –Fall 2013 – PLEASE STAPLE, DUE, Wednesday, November 20 at the beginning of class. NO LATE HWS ACCEPTED –

YOU MUST USE THIS AS A TEMPLATE – Please be a neat as possible, especially with graphs and please show all work. HIT ENTER TO MAKE ROOM FOR YOUR ANSWERS. PLEASE STAPLE!

THE TERM AND RISK STRUCTURE OF INTEREST RATES

In this HW assignment we are going to consider 4 specific relatively recent episodes in the US economy – 2 of the 4 apply mainly to the term structure of interest rates and the other two apply mainly to the risk structure of interest rates. In this assignment you are getting your hands dirty with real economic data (interest rates) and then you graph the data and interpret (You need to know a little about excel – if you need help see me or a friend)!

1) EPISODE #1! GREENSPAN THE HAWK!!! It was November 1994 and the US economy had just ‘gotten through’ the jobless recovery following the 1990 – 91 recession. The graphic below helps us understand what Greenspan was thinking – The Fed has a dual mandate and unemployment rates above 7% is certainly not consistent with the full employment objective. As such, Greenspan was dovish in the sense that he continued to lower the federal funds rate until it hit 3% (see FF graphic). At the time, inflation was running about 3% which implied the real federal funds rate was zero, certainly falling into the category of easy or expansionary policy. What we are interested in is the behavior of the yield curve towards the end of this episode.

BOTH GRAPHICS – MONTHLY DATA (8/1990 – 11/1994)

Note that during 1994 the Fed was quite aggressive in raising the funds rate and this is when AG showed his “Hawk-like qualities.” In particular, the funds target rose from 3% to 4.75% during the first 10 months of 1994. Greenspan, as was the norm, was looking very closely at the behavior of the 10 year Treasury. In what follows, you are to examine the behavior of the yield curve during this job-less recovery episode. To do so, we need data on the three – month T-bill and the 10 year Treasury (Click Here for the T-bill data and Here for the 10 year Treasury data).[1] Please choose “download data” and create a worksheet with data that begins in August 1990 and goes through to the present (we will use data later in the sample in a different episode). Your worksheet should begin looking just like the one below.

Below is an excerpt from

Fed Chief’s Style: Devour the Data, Beware of Dogma

As Retirement Looms in 2006, Greenspan’s Strong Record Will Be Hard to Replicate

Did He Help Create a Bubble?

By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
November 18, 2004; Page A1

1994: Soft Landing

In the first eight months of 1994, in a bid to slow the economy, the Fed raised its short-term interest rate five times, or a total of 1.75 percentage points, to 4.75%. The Greenspan Fed had a long tradition of moving in small increments, hoping to give officials time to assess the impact on corporate borrowing or consumer spending before moving again. Changing rates too rapidly, the theory went, risked an unnecessarily sharp slowdown and higher unemployment.

But the economy showed no signs of slowing. Investors still worried about inflation — then running at an annual rate of about 3%. That concern led the bond market to drive up long-term interest rates. When bond buyers worry their investment will be eroded by inflation, they typically demand a higher rate of return as compensation (THIS IS THE FISHER EFFECT!!!).

The Fed’s challenge was to raise rates enough to slow growth and yet also contain inflation — an elusive combination called a “soft landing.” But the Fed might raise rates too much, or the inflation-obsessed bond market could drive up long-term interest rates too high, causing the economy to fall into recession with a “hard landing.” THIS IS WHY THE FED IS SO VIGILANT ON ANCHORING INFLATION EXPECTATIONS BECAUSE IF THEY BECOME UNANCHORED, POLICY BECOMES VERY DIFFICULT VERY FAST.

In November 1994, Mr. Greenspan made a dramatic proposal to the Federal Open Market Committee, the body that votes on interest rates: Jack up the Fed’s key short-term interest rate by three-quarters of a percentage point in one shot, something he had never recommended before. Mr. Greenspan believed such a move would demonstrate the Fed’s resolve and finally stamp out inflation worries (TOTALLY HAWKISH)

“I think that we are behind the curve,” he told the Fed’s policy committee, transcripts show. Doing less, he said, could undermine confidence in the Fed’s ability to control inflation. With none of the ambiguity that marked his public statements, Mr. Greenspan said such an eventuality could provoke a “run on the dollar, a run on the bond market, and a significant decline in stock prices.”

Some of the six other governors and 12 regional bank presidents who made up the FOMC worried Mr. Greenspan was overdoing it. Especially concerned were two new Clinton-appointed governors, Janet Yellen and Mr. Blinder, academic economists inclined at the time to worry more about unemployment than inflation. THIS IS THE DEFINITION OF BEING DOVISH “There is a real risk of a hard landing, instead of a soft landing, if we are too impatient and overreact,” Ms. Yellen, who is now president of the San Francisco regional bank, told the committee.

a) (10 points) We know that the Yield curve typically slopes upward due to the term premium and we also know that the Yield Curve slopes upward when short rates are abnormally low. Greenspan was watching the 10 year and the slope of the yield curve carefully during the Fed’s tightening of 1994 and was upset. Why was he upset exactly? Use the real data that you downloaded and use the Fisher equation and Fisher effect to buttress your argument.

b) (10 points) As a result of these developments, Greenspan decided to crank the funds rate target up by 75 basis points at the November 1994 FOMC meeting. Greenspan continued to watch the 10 year very closely and was he satisfied with the result? Why or why not? Explain. Consider the movement of the 10 year from November 1994 through June of 1995.

c) (10 points) Now draw two yield curves on the same diagram. The first, label YC_11/94 and the second label YC_6/95 being sure to label everything with actual numbers!. Comment on the difference in the shape and what this means, theoretically in terms of the future path of short term interest rates employing the pure expectations theory of the term structure. Be sure to explain how and why the 75 basis point move at the November meeting seems to have ‘done the trick.’

d) (5 points) Finally, I often use the following phrase and sometimes suggest to students to go home over Thanksgiving and tell their parents that the Fed lowers interest rates by raising them! Is there any merit to the phrase given this episode of 1994? Why or why not?

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