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Homework Assignment #4– Econ 351 –Fall 2011 –. PLEASE STAPLE, DUE, Tuesday November 15. 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 – we have 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.
1
We could use some more rates in between the T-bill and the 10 year to get a more accurate yield curve but
these two rates will do the job.
1
3 month T bill
1990-08-01
1990-09-01
1990-10-01
1990-11-01
1990-12-01
10 Year Treasury
7.69
7.60
7.40
7.29
6.95
8.75
8.89
8.72
8.39
8.08
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.
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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 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 YC11/94 and the second
label YC6/95 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?
EPISODE #2 – THE RUSSIAN FINANCIAL CRISIS OF 1998. For this episode, we are going to focus on
the risk structure of interest rates and the signal it sends as to the state of affairs in the credit markets. We
are again going to download and graph some data. In this exercise, we are using daily data. We can do
this with two series, the rate on 3 month AA financial commercial paper and our friend, the 3 –month T-bill
(daily). Note how we match maturities, critical when evaluating the risk structure of interest rates. Click
Here for the commercial paper data and Here for the T-Bill data. Parse your data so that it begins in Jan
1998 and continues through to the present (we use the later data for Episode #4) Make a third column and
call it the spread (icp – iT-Bill). The spread is the signal!! The beginning of your worksheet should look like
the one below:
1998-01-01
1998-01-02
1998-01-05
1998-01-06
1998-01-07
1998-01-08
1998-01-09
1998-01-12
1998-01-13
1998-01-14
1998-01-15
3month commercial
paper
#N/A
5.57
5.53
5.51
5.48
5.48
5.42
5.39
5.37
5.41
5.41
3M T-Bill
#N/A
5.32
5.23
5.22
5.23
5.13
5.05
5.12
5.17
5.18
5.13
spread
#N/A
0.25
0.3
0.29
0.25
0.35
0.37
0.27
0.2
0.23
0.28
a) (5 points) Note the relatively low spread during the beginning of 1998. What does a low spread indicate
with regard to these credit markets? As a hint, think about what it would mean if the spread was zero!
b) (10 points for explanation) The Russian default occurred on August 17, 1998 Please graph (10 points for
correct graph) the paper – bill spread from August 17, 1998 until November 30, 1998 (line graph using
excel) and comment on the movement of the spread during this time period. Be sure to explain why the
spread changed during this period and what signal it sent to policy makers. Was the movement in the
spread due primarily to changes in the paper rate or changes in the rate on T-Bills or a little of both? Why
would we expect the T-bill to move as it did during this crisis?
c) (10 points) On what day, during the fall of 1998 did the spread hit its highest point at what did the Fed
do about it. Click Here for some help. In your answer, provide all the policy changes conducted by the
FOMC during the fall of 1998.
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EPISODE #3 – THE CONUNDRUM!!! During the ‘Jobloss’ recovery following the 2001 recession,
Greenspan arguably kept interest rates “too low for too long.” In this episode, we turn our attention to the
tightening cycle that began June 30, 2004. Beginning with this meeting, the Fed raised the target for the
federal funds rate by 25 basis points 17 FOMC meetings in a row.
a) (10 points) – according to the pure expectations theory of the term structure (PET), comment on the
implied movement of long term interest rates such as the 10 year Treasury. Please explain using the
equation that determines the yield on 10 year Treasury according to PET.
b) (5 points) We now consider the facts and the so-called conundrum. Using the worksheet that you created
for Episode #1 (monthly), consider the level of the T-Bill and compare it to the rate on the 10 year in May
2004, a month before the tightening cycle began. Is the slope of the yield curve during this time consistent
with PET and the term structure facts? Why or why not?
c) (10 points) Now consider the sample period from May 2004 through December 2006. Comment on the
movement of the T-Bill and compare to the movement on the 10 year. Are these movements consistent
with PET? Why or why not?
d) (10 points) Using the liquidity premium theory of the term structure (write it out), give an alternative
explanation of the facts – that is, explain why short rates kept going up but the 10 year didn’t budge! Click
Here for a big hint.
EPISODE #4: THE BEGINNING OF THE GREAT RECESSION AND THE COLLAPSE OF LEHMAN
BROTHERS. In this problem, we are going to let the data on the risk structure of interest rates, the daily
data, identify the beginning of the Great Recession as well as identify the collapse of Lehman Brothers.
a) (10 points for graph and 10 points for explanation) Provide a graph of the paper – bill spread during the
entire month of August 2007. Identify the date that this spread peaked and was the Fed and the FOMC
doing anything about it – if so, what? Go Here for some help! Be sure to include all the Fed’s activity
during August of 2007.
b) (10 points for graph and 5 points for explanation) We now consider the Lehman collapse – this occurred
as you may know during September 2008. Provide a graph of the paper – bill spread during the entire
month of September 2008 (again, use excel). Identify the date that this spread peaked and is this the date
that Lehman went down? What else was happening during this week? Click Here for some help.
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