Does Macroeconomics Help Understand the Term Structure of Interest Rates?

The expectations model of the term structure states that the yields to maturity of long term bonds are equal to the average of expected future short-term bond yields.This venerable model has been subjected to numerous empirical tests and almost invariably rejected. The empirical failure is generally attributed either to systematic expectations errors, or to shifts in the risk premia. In fact, the empirical tests, based on the estimation of single-equation models, are not able to discriminate between these two hypotheses. A recent strand of the macroeconomic literature has analyzed monetary policy by including the central bank reaction function in small empirical macro models. By simulating these models forward it is possible to derive the full forward path of short-term interest rates and hence to construct any long-term interest rate consistent with the expectations model. A\ direct test of the theory, based on full-information, can then be immediately constructed by comparing observed long-term rates with the simulated ones and the associated 95 per cent confidence interval. This is what we do in this paper. Our results shed new light on the empirical validity of the expectations model.