The Federal Reserve Bank of Kansas City's Research staff produces a series of working papers presenting results of the department's economic research. These technical papers cover a wide range of economic research topics.


Choosing Information Variables for Transition Probabilities In a Time-Varying Transition Probability Markov Switching Model

By Andrew J. Filardo (RWP 98-09 December 1998)
This paper discusses a practical estimation issue for time-varying transition probability (TVTP) Markov switching models. Time-varying transition probabilities allow researchers to capture important economic behavior that may be missed using constant (or fixed) transition probabilities. Despite its use, Hamilton’s (1989) filtering method for estimating fixed transition probability Markov switching models may not apply to TVTP models. This paper provides a set of sufficient conditions to justify the use of Hamilton’s method for TVTP models. In general, the information variables that govern time-variation in the transition probabilities must be conditionally uncorrelated with the state of the Markov process.

JEL Classification: C22, C13
Keywords: Markov switching; time-varying transition probabilities; maximum likelihood estimation

Credit Spreads and Interest Rates: A Cointegration Approach

By Charles Morris, Robert Neal & Doug Rolph (RWP 98-08 December 1998)
This paper uses cointegration to model the time-series of corporate and government bond rates. We show that corporate rates are cointegrated with government rates and the relation between credit spreads and Treasury rates depends on the time horizon. In the short-run, an increase in Treasury rates causes credit spreads to narrow. This effect is reversed over the long-run and higher rates cause spreads to widen. The positive long-run relation between spreads and Treasuries is inconsistent with prominent models for pricing corporate bonds, analyzing capital structure, and measuring the interest rate sensitivity of corporate bonds.

Term Structure Views of Monetary Policy

By Sharon Kozicki & P.A. Tinsley (RWP 98-07 September 1998)
Term structure models and many descriptions of the transmission of monetary policy rest on the empirical relevance of the expectations hypothesis. Small differences in the perceived policy reaction function in VAR models of agent expectations strongly influence the relevance in the transmission mechanism of the expected short rate component of bond yields. Mean-reverting or difference-stationary characterizations of interest rates require large and volatile term premiums to match the observable term structure. However, short rate descriptions that capture shifting perceptions of long-horizon inflation evident in survey data support a more substantial term structure role for short rate expectations.

Keywords: Expectations hypothesis, nonstationary inflation, shifting endpoint.

Market Reaction to Monetary Policy Nonannouncements

By V. Vance Roley & Gordon H. Sellon, Jr. (RWP 98-06 March 6, 1998; Last Revised: August 21, 1998)
This paper examines how Treasury security yields, stock prices, and federal funds futures rates respond on Federal Open Market Committee (FOMC) meeting dates when expected policy actions do not occur. The empirical results support the existence of nonannouncement effects on short- and intermediate-term yields. In particular, part of an expected policy action, measured using federal funds futures rates, is unwound when the action does not materialize. This partial unwinding is consistent with markets reacting to the surprise by postponing, but not eliminating, the possibility of a future policy action. We also find that only the response of near-term federal funds futures rates is larger after February 1994, when the Federal Reserve began making virtually all of its nonzero changes in the federal funds rate target at FOMC meetings. As a whole, our results suggest that monetary policy decisions can be informative to financial markets even when these decisions do not involve an overt policy action, and they support the view that market expectations of future policy actions are an important determinant of the behavior of interest rates.

The Real-Time (In)Significance of M2

By Jeffery D. Amato (RWP 98-05 September 1998)
This paper examines the relationships between output, prices, interest rates, and M2 using data sets which were available in real time from 1973:1 to 1997:4. The purpose is threefold. First, the paper delineates a potential role for M2 in policymaking. Second, it provides a more accurate basis for interpreting historical policymaking. Third, it evaluates the cause and effect of the historical redefinitions of M2. The latter two objectives make it necessary to use data which was available to policymakers at the time decisions were made. In regard to the first objective, the approach is both novel and complementary to the existing literature.

JEL Classification: E52
Keywords: Granger causality, variance decomposition, money rule, data revision.

The Sources of Fluctuations Within and Across Countries

By Todd E. Clark & Kwanho Shin (RWP 98-04 September 1998)
This paper reviews the evidence on the sources of business cycles within and across countries and the implications for the importance of borders in business cycles. A simple econometric model is presented and applied to within-U.S. and cross-country data in order to provide a framework for interpreting the literature. Using these estimates as a benchmark, data issues, alternative models, and still other approaches to quantifying sources of comovement are surveyed. Overall, the evidence suggests three general conclusions. First, common shocks are less important in international fluctuations than in within-country fluctuations. Second, region-specific shocks account for a larger share of variation in international data than in within-country data. Finally, industry-specific shocks, measured accurately, are a smaller source of variation internationally than within countries. The paper then argues that lowering economic borders among nations through pacts like EMU should make the sources of international fluctuations look somewhat more like the sources of within-country fluctuations, although the effects are uncertain.

Vector Rational Error Correction

By Sharon Kozicki & P.A. Tinsley (RWP 98-03 August 1998)
Systems of forward-looking linear decision rules can be formulated as vector "rational" error correction models. The closed-form solution of the restricted error corrections is derived, and a full-information estimator is suggested. The error correction format indicates that the assumptions of convex adjustment costs and rational expectations impose different types of a priori restrictions on the dynamic structure of the error corrections. An empirical model of the producer decision rule for capital investment illustrates that the data rejects dynamic restrictions imposed by a standard model of adjustment costs but supports a more general description of convex frictions.

Keywords: Adjustment costs, capital equipment, companion systems, vector error correction.

Predicting Inflation With the Term Structure Spread

By Sharon Kozicki (RWP 98-02 August 1998)
It is tempting to interpret empirical evidence in a number of recent studies as suggesting that term structure spreads help predict future inflation over moderate horizons of 3 to 5 years. This paper argues that common measures of the predictive power of the term structure spread for future inflation are misleading. In particular, R2s for estimated inflation-change equations can drastically overstate the predictive power of spreads. The paper explains why the overstatement is likely to be particularly large in countries whose monetary authorities have strong reputations for credibly targeting a stable inflation rate. Results from an empirical analysis of data from eleven industrialized countries suggest that the level of the short-term real rate may be more useful for predicting inflation than the term structure spread, possibly because changes in short-term real rates provide clearer measures of changes in the stance of monetary policy.

JEL: E37, E43, F47, E52
Keywords: Expectations, Hypothesis, Fisher Hypothesis.

A Model of Financial Fragility

By Roger D. Lagunoff and Stacey L. Schreft (RWP 98-01 November 1997: Last revised September 1998)
This paper presents a dynamic, stochastic game-theoretic model of financial fragility. The model has two essential features. First, interrelated portfolios and payment commitments forge financial linkages among agents. Second, iid shocks to investment projects’ operations at a single date cause some projects to fail. Investors who experience losses from project failures reallocate their portfolios, thereby breaking some linkages. In the Pareto-efficient symmetric equilibrium studied, two related types of financial crises can occur in response. One occurs gradually as defaults spread, causing even more links to break. An economy is more fragile ex post the more severe this financial crisis. The other type of crisis occurs instantaneously when forward-looking investors preemptively shift their wealth into a safe asset in anticipation of the contagion affecting them in the future. An economy is more fragile ex ante the earlier all of its linkages break from such a crisis. The paper also considers whether fragility is worse for larger economies.