Market Anticipation of Fed Policy Changes and the Term Structure of Interest Rates

Abstract:     
The Federal Reserve adjusts the target federal funds rate discretely, causing discontinuity in short-term interest rates. However, unlike random Poisson jumps, these adjustments are well anticipated by the market. Within the affine term structure framework, we incorporate an anticipated jump component with known arrival times, but random jump size. We find that doing so improves the model performance in capturing the term structure behavior. When we examine anticipated jump components for the term structure in other economies, we find that it is present in the euro term structure, but absent from Japanese interest rates.

Keywords: Federal Reserve, term structure, federal funds rate, market expectation, deterministic jumps, random Poisson jumps, fed fund futures

JEL Classifications: E43, G12, G13, C51

Working Paper Series