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Treasury Yields and Economic News Article

The article in question is "Treasury Prices Drift Lower As Stock Market Stages Rally" published in the Wall Street Journal on Monday, April 12th 2003.

I) The article above says, "Underlying the Treasury market's limited downside Monday is the broad-based concern that even with the war in Iraq having been completed, economic activity has still yet to pick up in any meaningful way." Using the expectations hypothesis and the Taylor rule provide an interpretation of this comment in the article.

ii) The last paragraph of the above article says, "But of far more importance will be Federal Reserve Chairman Alan Greenspan's testimony on the economy on Wednesday, along with the release Friday of the April employment situation report." Suppose the economic release on Friday (i.e., May 2nd) shows that the number of jobs (payroll) in the last month increased in the U.S. economy more than what is expected; how will this affect the price of the 30 year Treasury bond and equity prices? Provide an economic justification for your answer.

Solution Preview

Hi,

Here is some information that should assist you with your questions:

1) Using the expectations hypothesis and the Taylor rule provide an interpretation of this comment in the article.

Background info:

Taylor's rule is a formula developed by Stanford economist John Taylor. It was designed to provide "recommendations" for how a central bank like the Federal Reserve should set short-term interest rates as economic conditions change to achieve both its short-run goal for stabilizing the economy and its long-run goal for inflation.

Specifically, the rule states that the "real" short-term interest rate (that is, the interest rate adjusted for inflation) should be determined according to three factors: (1) where actual inflation is relative to the targeted level that the Fed wishes to achieve, (2) how far economic activity is above or below its "full employment" level, and (3) what the level of the short-term interest rate is that would be consistent with full employment. The rule "recommends" a relatively high interest rate (that is, a "tight" monetary policy) when inflation is above its target or when the economy is above its full employment level, and a relatively low interest rate ("easy" monetary policy) in the opposite situations. Sometimes these goals are in conflict: for example, inflation may be above its target when the economy is below full employment. In such situations, the rule provides guidance to policy makers on how to balance these competing considerations in setting an appropriate level for the interest rate.

Although the Fed does not explicitly follow the rule, analyses show that the rule does a fairly accurate job of describing how monetary policy actually has been conducted during the past decade under Chairman Greenspan. This fact has been cited by many economists inside and outside of the Fed as a reason that inflation has remained under control and that the economy has been relatively stable in the US over the past ten years.

The expectations hypothesis is a theory of the term structure of interest rates that describes a conventional view of the transmission ...

Solution Summary

This solution is comprised of background on the Taylor rule and then a detailed explanation of the impacts that comments from the US Federal Reserve Chairman can have on the price of 30 Year Treasury Bonds and Equity prices. 1380 words.

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