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The unusual behavior of the federal funds and 10-year Treasury rates: a conundrum or Goodhart’s Law?

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Daniel L. Thornton

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Abstract

In February 2005, former Chairman Alan Greenspan referred to the decline in long-term rates in the wake of the Fed increasing the target for the federal funds rate by 150 basis points as a “conundrum.” Greenspan’s remarks generated considerable interest and research. I show that the relationship between the 10 year Treasury yield and the federal funds rate changed dramatically in the late 1980s, well in advance of Greenspan’s observation. I argue that the marked change in the relationship between the federal funds rate and long-term yields is a natural consequence of Goodhart’s Law.

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2007-039.

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Date of creation: 2008
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Handle: RePEc:fip:fedlwp:2007-039

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Keywords: Federal funds market (United States) ; Government securities;

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This paper has been announced in the following NEP Reports: References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. William Poole & Robert H & Rasche & Daniel L. Thornton, 2002. "Market anticipations of monetary policy actions," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 65-94. [Downloadable!]
  2. Ben S. Bernanke & Vincent R. Reinhart & Brian P. Sack, 2004. "Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 35(2004-2), pages 1-100. [Downloadable!]
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  3. William Poole, 2007. "Milton and money stock control," Speech, Federal Reserve Bank of St. Louis. [Downloadable!]
  4. Daniel L. Thornton, 2007. "The lower and upper bounds of the Federal Open Market Committee's long-run inflation objective," Review, Federal Reserve Bank of St. Louis, issue May, pages 183-194. [Downloadable!]
  5. Don H. Kim & Athanasios Orphanides, 2005. "Term structure estimation with survey data on interest rate forecasts," Finance and Economics Discussion Series 2005-48, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  6. Glenn D. Rudebusch & Tao Wu, 2007. "Accounting for a Shift in Term Structure Behavior with No-Arbitrage and Macro-Finance Models," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(2-3), pages 395-422, 03. [Downloadable!] (restricted)
  7. Diebold, Francis X. & Chen, Celia, 1996. "Testing structural stability with endogenous breakpoint A size comparison of analytic and bootstrap procedures," Journal of Econometrics, Elsevier, vol. 70(1), pages 221-241, January. [Downloadable!] (restricted)
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  8. Edward Nelson, 2005. "The Great Inflation of the Seventies: What Really Happened?," Advances in Macroeconomics, Berkeley Electronic Press, vol. 5(1), pages 1297-1297. [Downloadable!] (restricted)
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  9. Rudebusch, Glenn D., 1995. "Federal Reserve interest rate targeting, rational expectations, and the term structure," Journal of Monetary Economics, Elsevier, vol. 35(2), pages 245-274, April. [Downloadable!] (restricted)
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  10. Thornton, Daniel L., 2004. "The Fed and short-term rates: Is it open market operations, open mouth operations or interest rate smoothing?," Journal of Banking & Finance, Elsevier, vol. 28(3), pages 475-498, March. [Downloadable!] (restricted)
  11. Don H. Kim & Jonathan H. Wright, 2005. "An arbitrage-free three-factor term structure model and the recent behavior of long-term yields and distant-horizon forward rates," Finance and Economics Discussion Series 2005-33, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  12. Glenn D. Rudebusch & Eric T. Swanson & Tao Wu, 2006. "The bond yield "conundrum" from a macro-finance perspective," Working Paper Series 2006-16, Federal Reserve Bank of San Francisco. [Downloadable!]
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  13. Troy Davig & Eric M. Leeper, 2007. "Generalizing the Taylor Principle," American Economic Review, American Economic Association, vol. 97(3), pages 607-635, June. [Downloadable!]
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Daniel L. Thornton, 2008. "Monetary policy: why money matters and interest rates don't," Working Papers 2008-011, Federal Reserve Bank of St. Louis. [Downloadable!]
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