The Federal Reserve sets targets for interest rates which it enforces through direct market intervention. These targets are changed periodically. In this paper we develop a term structure model in which the short rate is subject to a control which keeps it close to a target which changes from time to time. The probability of target changes is not constant in the model but changes as a function of observables. The model performs well at explaining the shifts in the yield curve that accompany target changes. In U.S. financial markets the Federal Reserve Bank (the Fed) is a unique player. Usually we assume that market participants are price takers in financial markets. However, there is evidence that this is not true of the Fed. In fact, the Fed sets targets for short-term rates which it attempts to maintain by market intervention, injecting or withdrawing funds from the market to keep the rates near their targets. Targets are changed from time to time and market participants know when such a target change occurs. They may, in fact, have some limited ability to forecast such target changes.

Conference. In particular, I am grateful to an unknown RFS referee, Kerry Back, Michael Brennan, Darrell Du e,

to specify an appropriate stochastic differential equation is for the most part an unanswered question. For example, many different continuous-time The comments and suggestions of Kerry Back (the editor) and an anonymous referee were very helpful. I am also grateful to George Constantinides,

and the 2009 AFA conferences for very helpful suggestions. I am indebted to Kerry Back,

and the 2009 AFA conferences for very helpful suggestions. I am indebted to Kerry Back, Phil Dybvig, and Pietro Veronesi for their constructive comments that have significantly improved the paper. Send correspondence to Hong Liu at Olin Business School, Washing-

snap back, exhibiting tension. Scale bar = 10 mm. Reprinted with permission from

, respectively quadratic, vari-ation. Finally, we provide equilibrium implications and illustrate the model’s broader applicability to economics. ∗We are grateful for helpful comments from Kerry Back, Darrell Duffie, Pierre Collin-Dufresne,

, respectively quadratic, variation. Finally, we provide equilibrium implications and illustrate the model’s broader applicability to economics. ∗We are grateful for helpful comments from Kerry Back, Darrell Duffie, Pierre Collin-Dufresne, Andrea

of the agents ’ incentive problems. ∗I am especially grateful to Philip Dybvig for his invaluable comments and discussions. I would also like to thank Kerry Back, Vladimire Mares, Todd Milbourn, and Chakravarthi Narasimhan for their helpful suggestions. All errors remain of course my responsibility.

, University of Colorado. I would like to thank Kerry Back, Jeroen Swinkels and John Nachbar for comments on a chapter of my dissertation on which this article is based. I would like to thank Jaime Zender and Eric Hughson for additional comments.