Were financial market participants'' expectations correct

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The Volcker disinflation and the term structure

In the late 1970s, the U.S. inflation rate reached double digits. Paul Volcker was appointed chairman of the Federal Reserve Board in 1979. Volcker was considered the right person to lead the fight against inflation. In this problem, we will use yield curve data to judge whether the financial markets were indeed expecting Volcker to succeed in reducing the inflation rate.
Go to the data section of the Web site of the Federal Reserve Bank of St. Louis (www.research.stlouisfed.org/fred2). Go to "Consumer Price Indexes (CPI)" and download monthly data on the seasonally adjusted CPI for all urban consumers for the period 1970 to the latest available date. Import it into your favorite spreadsheet program. Similarly, under "Interest Rates" and then "Treasury Constant Maturity," find and download the monthly series for "1-Year Treasury Constant Maturity Rate" and "30-Year Treasury Constant Maturity Rate" into your spreadsheet.

a. How can the Fed reduce inflation? How would this policy affect the nominal interest rate?

b. For each month, compute the annual rate of inflation as the percentage change in the CPI from last year to this year (i.e., over the preceding 12 months). In the same graph, plot the rate of inflation and the one-year interest rate from 1970 to the latest available date. When was the rate of inflation the highest?

c. For each month, compute the difference (called the spread) between the yield on the 30-year T-bond and the one-year T-bill. Plot it in the same graph with the one-year interest rate.

d. What does a declining spread imply about the expectations of financial market participants? As inflation was increasing in the late 1970s, what was happening to the one-year T-bill rate? Were financial market participants expecting that trend to continue? In October 1979, the Fed announced several changes in its operating procedures that were widely interpreted as a commitment to fighting inflation.

e. Using the interest rate spread that you computed in part (c) for October 1979, do you find any evidence of such an interpretation by financial market participants? Explain. In early 1980, it became obvious that the United States was falling into a sharp recession. The Fed switched to an expansionary monetary policy from April to July 1980 in order to boost the economy.

f. What was the effect of the policy switch on the one-year interest rate?

g. From April to July 1980, did financial markets expect the change in policy to last? Explain. Were financial market participants' expectations correct?

Reference no: EM131145674

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