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Understand Term Structure of Interest

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From the article titled with “Understanding the Term Structure of Interest Rate “by William Poole published on September 2005 have discussed about the matter between the long-term interest rates and short-term interest rates over the years. According to his analysis, it is say that the long-term rates will generally raise as the short-term interest rates raised by the monetary policy. However, the long-term rates will only increase with a smaller amount compared with the short-term rates. Thus, from the recent increase in short-term interest rates, which this statement is not applicable. It analysis that the short-term rates and long-term rates are not the same within the expectations theory of the term structure of interest rates. It is also known as a puzzle by some of them, as they think that it is because the miscarriage of U.S. Federal policy.

As what we have found from the latest term structure puzzle in the article, the Federal Open Market Committee (FOMC) have actually risen up the federal fund target rate from their every meeting at 25 basis points, which is increase from 1% to 3% as of 3rd of May, 2005. The rate on a 10-year U.S Treasury Bill was around 4.5% in the mid of the year of 2002, while there is no clearly define that there is upward or downward trend in June 2005. From the pass, there is an average increase of 32 basis points in long-term rates for each 100 basis points raise up in short-term rates. The increase in long-term rates of 65 basis points will take place if the average historical behaviour remain unchanged. The failure of long-term rates is embodying from the puzzle.

For instance, a 10-year bond rate which is started in June 2004 with the one-year rate and the another nine 1-year have the same one year rates in expectation. The expectation of the another nine 1-year rate that have been channel by the 10-year rate of bond from June 2005 is to be used as contradistinction with the bond’s expectation of June 2004. As of the news about the economy and inflation, causes the 10-year rate goes up and down. The future real economic activity will probably to be affected by the expected real rate of interest. The expected monetary policy and future inflation are integrating simultaneously to the expected nominal rate.

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