Working Paper: NBER ID: w2363
Authors: Kenneth A. Froot
Abstract: Survey data on interest rate expectations are used to separate the forward interest rate into an expected future rate and a term premium. These components are used to test separately two competing alternative hypotheses in tests of the term structure: that the expectations hypothesis does not hold, and that expected future long rates over- or underreact. to changes in short rates. While the spread consistently fails to predict future interest rate changes, we find that the nature of this failure is different, for short versus long maturities. For short maturities, expected future rates are rational forecasts. The poor predictions of the spread can therefore be attributed to variation in term premia. For longer-term bonds, however, we are unable to reject the expectations theory, in that a steeper yield curve reflects a one-for-one increase in expected future long rates. Here the perverse predictions of the spread reflect investors' failure to raise sufficiently their expectations of future long rates when the short rate rises. We confirm earlier findings that bond rates underreact to short rate changes, but now this result cannot be attributed to the term premium.
Keywords: Expectations Hypothesis; Term Structure; Interest Rates
JEL Codes: E43; E44
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| expected future long rates underreact to changes in short rates (E43) | systematic failure of the expectations hypothesis (D84) |
| spread fails to predict future interest rate changes (E43) | expectations hypothesis does not hold universally (D84) |
| expected future rates are rational forecasts (G17) | predictions based on the spread can be attributed to variations in term premia (G17) |
| investors fail to sufficiently adjust expectations of future long rates when short rates rise (E43) | bond rates underreact to short rate changes (E43) |
| poor predictive power of the spread (C59) | systematic expectational errors (D84) |
| excessive volatility of long rates in response to changes in the spread (E43) | poor predictive power of the spread (C59) |