Changes in the Relationship Between the Long-Term Interest Rate and Its Determinants

Changes in the Relationship Between the Long-Term Interest Rate and
its Determinants by William Lee and Eswar Prasad

From October 1993 to June 1994, long-term interest rates in the United
States rose by about 1 1/2 percentage points, substantially more than the
increase in short-term rates and despite the relatively stable inflation
during this period. The purpose of this paper is to assess the quantitative
importance of various explanations for the increase in long-term rates and
to investigate whether this increase can be explained using standard models
of the term structure of interest rates.

This study finds evidence that the estimated coefficients from a
standard term structure equation--that models the long rate as a function of
a long distributed lag on realized short-term rates--may have changed
substantially since the early 1980s. Further, this equation performs poorly
after 1993, apparently because it is unable to capture adequately the
important role of expectations regarding current and prospective monetary
policy in determining the level of long-term interest rates.

The responsiveness of the long-term rate to monetary policy appears to
have increased since the early 1980s. This is illustrated by comparing
changes in long- and short-term rates during periods of monetary policy
tightening. In addition, it is shown that the estimated coefficient from a
simple regression of the change in the long-term rate on the change in the
federal funds rate has more than doubled since 1989.

The standard term structure equation is then augmented by the addition
of variables that proxy for the stance of monetary policy and that attempt
to control for the effects of portfolio shifts. The augmented equation
tracks variations in the long-term rate significantly better than the
traditional term structure equation. However, the augmented specification
also shows signs of a structural break in the 1980s. The coefficients on
the monetary policy, economic activity, and portfolio shift variables
increase in absolute magnitude when the equation is estimated over the 1984-
94 period. Thus, an important finding of this paper is that the sensitivity
of long-term interest rates to changes in current and prospective monetary
policy has increased significantly since the early 1980s.