The Term Structure of Interest Rates

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THE QUARTERLY JOURNAL OF Vol. LXXI ECONOMICS November, 1957 No. 4 THE TERM STRUCTURE OF INTEREST RATES By J. M. CULBERTSON* I. The elements of term structure theory, 489. - II. The role of debt liquidity differences in the rate structure, 491. - III. The role of speculative activity in the term structure, 496. - IV. Changes in the maturity structure of demand for funds, 502. - V. Yields on short-term and long-term U. S. government securities 1920-1957, 504. - VI. Some implications for credit policy, 516. This paper develops a theory of the maturity structure of interest rates applicable in particular to developments in markets for U. S. government debt in modern times. It applies the theory to broad changes in the rate structure since 1920, and examines some of its implications for economic stabilization policies. The theory of the term structure of interest rates, although it has not figured in the renowned controversies over the theory of "the interest rate," has concerned both students of credit control and active participants in debt markets. Among the earlier economists who sought to explain the interest rate structure, J. B. Say' and Henry Sidgwick2 made sensible contributions that could have served as a basis for further development of a realistic theory. However, relatively little attention was paid to this area of theory until the end of the 1920's, at which time there appeared several important works dealing with it. Karin Koch's A Study of Interest Rates' pointed out the significance of the behavior of the rate structure for monetary policy * This paper was written while the author was a member of the staff of the Board of Governors of the Federal Reserve System. The views expressed are personal views of the author and in no way reflect the position of the Board. The writer wishes to express appreciation to colleagues for comments on a draft of this paper. The paper is based upon a doctoral dissertation submitted at the University of Michigan in 1956, "A Theory of the Term Structure of Interest Rates." 1. A Treatise on Political Economy (Philadelphia, 1867), pp. 344-47. 2. The Principles of Political Economy (3d. ed.; New York and London, 1901), pp. 251-81. 3. London. 1929. 485
486 QUARTERLY JOURNAL OF ECONOMICS and engaged in a detailed discussion of institutional and theoretical considerations affecting the structure of rates. Irving Fisher's The Theory of Interest4 developed the relationship between short-term and long-term rates of interest under conditions of perfect foresight that later became the basis of the expectational theory of the term structure. However, his realistically oriented discussion emphasized the importance of institutional factors and the inapplicability of any precise theoretical formulation. His observations on the behavior of the rate structure suggest that short-term and long-term rates tend to move together, with short-term rates moving over a wider range.' Winfield W. Riefler's comprehensive study, Money Rates and Money Markets in the United States,6 generally supported the same conclusion. The author pointed up the compartmentalization of debt markets; however, the general relationship assumed to exist was one of competition among debts of different maturity on the basis of relative yields. The data compiled by the author for the 1920's on average market yields on typical shortterm and long-term private debt showed a general correspondence in direction and timing of movements, with short-term yields moving over a wider amplitudeJ Keynes in the Treatise on Money8 accepted the Riefler findings and sought to support them with data on British experience. He went on to argue that changes in short-term rates, which could be brought about by central bank action, were effectively communicated to long-term markets, and that it was mainly through this channel that monetary policy was effective.9 In the General Theory, however, in recognition of the reluctance of long-term rates to decline in the 1930's, he abandoned this doctrine. He sought to explain the long-term rate of interest as a "highly conventional" or a "highly psychological phenomenon," and emphasized the importance of expected future levels of long-term rates.' Apart from the main stream of development is Hawtrey's argument that changes in short-term rates caused by central bank action have little effect upon long-term rates, and that it is directly through the action of short-term rates upon the economy that monetary policy is effective.2 4. New York, 1930. 5. See pp. 313-14, and chap. IX (particularly pp. 209-10) on these points. 6. New York, 1930. 7. See particularly pp. 7-9 and 116-23. 8. London, 1930. 9. See particularly II, 352-64. 1. New York, 1936, pp. 202-4. 2. A Century of Bank Rate (London, 1938), pp. 184-95.
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