Investigating the effects of monetary regime shifts: The case of the Federal Reserve and the shrinking risk premium

In this paper we use Mishkin’s efficient markets framework [Journal of Finance 37 (1982) 63–72] to show that the founding of the Federal Reserve led to a greater than 50% reduction in the size of the risk (term) premium a 6-month instrument pays over a 3-month one, and that this reduction coincides with the significant reduction in the uncertainty of interest rates that took place during the same period. This result demonstrates a major impact this unparalleled US monetary regime shift had on financial markets and provides further confirmation of the importance of accounting for major institutional and policy changes when investigating the sources of changing intertemporal macroeconomic relationships.