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Tests of the expectations hypothesis: resolving the anomalies when the short-term rate is the federal funds rate

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  • Daniel L. Thornton

Abstract

The expectations hypothesis (EH) of the term structure plays an important role in the analysis of monetary policy, where shorter-term rates are assumed to be determined by the market’s expectation for the overnight federal funds rate. With two exceptions, tests using the effective federal funds rate as the short-term rate easily reject the EH. These exceptions are when the EH is tested over the nonborrowed reserve targeting period and when the test is performed only using data for settlement Wednesdays—the last day of bank’s reserve maintenance period. This paper argues that these exceptions are anomalous: In the former case, the failure to reject the EH occurs when economic analysis suggests that the market should be less able to forecast the federal funds rate. In the latter case, it occurs when there are sharp spikes in the funds rate that cannot improve materially the market’s ability to forecast the funds rate. Additional analysis shows that these anomalous results are a consequence of the procedure used to test the EH.

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Bibliographic Info

Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2000-003.

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Date of creation: 2004
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Publication status: Published in Journal of Banking and Finance, October 2005, 29(10), pp. 2541-56
Handle: RePEc:fip:fedlwp:2000-003

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Keywords: Rational expectations (Economic theory) ; Federal funds rate;

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Cited by:
  1. Della Corte, Pasquale & Sarno, Lucio & Thornton, Daniel L, 2007. "The Expectation Hypothesis of the Term Structure of Very Short-Term Rates: Statistical Tests and Economic Value," CEPR Discussion Papers 6445, C.E.P.R. Discussion Papers.
  2. Matteo Modena, 2008. "The Term Structure and the Expectations Hypothesis: a Threshold Model," Working Papers 2008_36, Business School - Economics, University of Glasgow.
  3. Daniel L. Thornton, 2012. "Monetary policy: why money matters, and interest rates don’t," Working Papers 2012-020, Federal Reserve Bank of St. Louis.
  4. Daniel L. Thornton, 2003. "Monetary policy transparency: transparent about what?," Working Papers 2002-028, Federal Reserve Bank of St. Louis.
  5. Clemens J.M. Kool & Daniel L. Thornton, 2012. "How effective is central bank forward guidance?," Working Papers 2012-063, Federal Reserve Bank of St. Louis.
  6. Daniel L. Thornton, 2012. "Evidence on the portfolio balance channel of quantitative easing," Working Papers 2012-015, Federal Reserve Bank of St. Louis.
  7. Massimo Guidolin & Daniel L. Thornton, 2010. "Predictions of short-term rates and the expectations hypothesis," Working Papers 2010-013, Federal Reserve Bank of St. Louis.
  8. M. Hadzi-Vaskov & C.J.M. Kool, 2006. "The importance of interest rate volatility in empirical tests of uncovered interest parity," Working Papers 06-16, Utrecht School of Economics.
  9. Morten L. Bech & Elizabeth Klee & Viktors Stebunovs, 2012. "Arbitrage, liquidity and exit: the repo and federal funds markets before, during, and emerging from the financial crisis," Finance and Economics Discussion Series 2012-21, Board of Governors of the Federal Reserve System (U.S.).
  10. Alain Durré, 2006. "The Liquidity Premium in the Money Market: A Comparison of the German Mark Period and the Euro Area," German Economic Review, Verein für Socialpolitik, vol. 7, pages 163-187, 05.

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