Dynamics of the Short-Term Interest Rate after the 1979–1982 Monetary Experiment

Abstract

Most of the recent empirical studies on the dynamics of the short-term interest rate focus on a period from the 1960s to the 1990s. By and large, these studies support the conclusion that interest rate volatility is highly sensitive to interest rate levels. The 1960–1990 period, however, is characterized by several distinct monetary policy regimes. Pricing interest rate sensitive-securities using model parameters estimated from any period is inappropriate unless there is a chance the Federal Reserve may readopt some abandoned operating procedures. This study focuses on the 1982–1996 period, a relatively long and stable environment of deemphasized monetary aggregates and targeted federal fund rates. The mean reversion tendency is very strong, which is in sharp contrast to the usual findings. While there is some evidence that the volatility of interest rate changes is related to interest rate levels, the sensitivity is much lower than previously reported. Finally, the Vasicek model cannot be rejected but the monthly data and the Cox, Ingersoll, and Ross model cannot be rejected by either the monthly or weekly data.