The expectations hypothesis (EH) of the term structure of interest rates–the proposition that the long term rate is determined by the market’s expectation of the short-term rate over the holding period of the long-term bond plus a (constant) risk premium–is one of the key economic principles that is at the core of the monetary policy transmission mechanism. Indeed, virtually every central bank conducts monetary policy by targeting a short-term rate. However, as noted by Woodford (1999, 2003) and others, the effectiveness of monetary policy depends critically on a central bank’s ability to affect longer-term rates that matter most for aggregate demand.
This has prompted at least four central banks–the Reserve Bank of New Zealand (since 1997), the Norges Bank (since 2005), the Swedish Riksbank (since 2007), and the Czech National Bank (since 2008)–to adopt formal policies of providing forward guidance about the path of the relevant short-term interest rate in an attempt to have a larger effect on longer-term interest rates via a typical EH-like mechanism (e.g., see Andersson and Hofmann, 2010). Moreover, the Fed appears to have used forward guidance beginning 2003 and more explicitly since December 2008. Indeed, Kocherlakota (2010) has recently suggested the Fed’s quantitative easing program might represent “(...) another form of forward guidance about the path of the fed funds rate.”
The recent trend among central banks to increase the effect of their interest rate policy on longer-term rate via the EH stands in stark contrast with the vast empirical evidence against it. The EH has been tested and rejected using a wide variety of interest rate series, over a variety of sample periods, alternative monetary policy regimes, etc. (e.g., Fama, 1984; Mankiw and Miron, 1986; Campbell and Shiller, 1991; Roberds et al., 1996; Kool and Thornton, 2004; Thornton 2005; Sarno, et al., 2007; and Della Corte, et al., 2008). The most common explanation for the EH’s failure is that the single equation models that have been most often used to test it are subject to spurious rejections because of time-varying risk premia, non-rational expectations, peso problems, measurement errors, etc.
However, none of numerous attempts to rescue the EH from such problems (e.g., Simon, 1990; Driffill et al., 1997; Tzavalis and Wickens, 1997; Balduzzi, et al. 1997; Roberds and Whiteman, 1999; Bekaert et al., 2001; Dai and Singleton, 2002; Bansal and Zhou, 2002; Hess and Kamara, 2005) has adequately accounted for the EH’s failure. The evidence against the EH is strengthened by Bekaert, Hodrick, and Marshall.’s (1997) demonstration that estimates from these models are even less favorable to the EH because of a positive small-sample bias in parameter estimates. The usefulness of these tests is further complicated by Thornton’s (2006) demonstration that single equation models can yield estimates favorable to the EH when the EH is false.
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Predictions of Short-Term Rates and the Expectations Hypothesis
