Fed Funds Rate Targeting, Monetary Regimes and the Term Structure of Interbank Rates: Explaining the Predictability Smile

We present an arbitrage-free model of the term structure of interest rates where the short rate is subject to rare jumps of predetermined magnitudes. A two dimensional hidden Markov switching process governs the jump probabilities. We apply the model to the targeting process of the Federal Reserve, interpreting the jumps as changes to the federal funds target, and the short rate as the market federal funds rate. We calibrate the model with money market and interbank spot curves, using an EM algorithm. The smoothed inference of the regime fits well with the historical evidence on the monetary policy stance. The model generates time-varying term premia at business cycle frequencies. The slow variation of the jump risk premia causes the expectations hypothesis of the term structure to break down at yearly horizons. We are able to qualitatively replicate the predictability smile in Campbell-Shiller yield spread regressions.