The Bond Price Support Program as a Change in Policy Regimes: Evidence from the Term Structure of Interest Rates

Abstract

RECENTLY, MANKIW, MIRON, AND WEIL (1987) argued that a change in policy regimes generally affects the public's expectations of future interest rates. To illustrate this influence, they compare the operation of the gold standard with the post-gold standard regime in the United States. They find that nominal short-term interest rates were mean-reverting before 1914, but became nonstationary after the creation of the Federal Reserve System. We extend Mankiw, Miron, and Weil's analysis by noting that the period from 1914 to the present cannot be characterized as one uninterrupted episode of policy discretion. The United States temporarily abandoned discretion for a rule in the 1940s. The Fed and Treasury agreed in April 1942 that the Fed would adjust Federal Reserve credit in a manner that would produce relatively low market rates on longterm securities. In particular, the Fed committed itself to support twenty-year government bond prices at a level consistent with a 2.5 percent interest rate ceiling. We investigate the possibility that the bond price support program of the 1940s conditioned the behavior of short-term interest rates in a predictable way. According to the expectation theory of the term structure, a binding long-term interest rate ceiling implies that an increase in the current short rate must cause the sum of the innovation and the change in future expected rates to be zero. Otherwise, the long rate rises above the ceiling and the public perceives a violation of the bond rate commitment. Placing a binding ceiling on long-term interest rates tends to make short-term interest rates mean-reverting.