The Effects of Monetary Policy Regime Shifts on the Term Structure of Interest Rates

We investigate how the entire term structure of interest rates is influenced by changes in monetary policy regimes. To do so, we develop and estimate an arbitrage-free dynamic term-structure model which accounts for regime shifts in monetary policy, volatility, and the price of risk. Our results for U.S. data from 1985-2008 indicate that (i) the Fed's reaction to inflation has changed over time, switching between "more active'' and "less active'' monetary policy regimes, (ii) on average, the slope of the yield curve in the "more active'' regime was steeper than in the "less active'' regime, and (iii) the yield curve in the "more active'' regime was considerably more volatile than in the "less active'' regime. The steeper yield curve in the "more active'' regime appears to reflect higher term premia that result from the risk associated with a more volatile future short-term interest rate given a more sensitive response to inflation