Predictions of short-term rates and the expectations hypothesis

This paper emphasizes that traditional tests of the EH are based on two assumptions: the expectations hypothesis (EH) per se and an assumption about the expectations generating process (EGP) for the short-term rate. Arguing that conventional tests of the EH need to assume EGPs that may be significantly at odds with the true EGP, we investigate this possibility by analyzing the out-of-sample predictive performances of several models for predicting interest rates, including a few models which assume that the EH holds in its functional form that relates long- to short-term yields. Using US riskless yield data for a 1970–2016 monthly sample and testing methods that take into account the parameter uncertainty, the null hypothesis of an equal predictive accuracy of each model relative to the random walk alternative is hardly ever rejected at intermediate and long horizons. This confirms that, at least at a practical level, the main difficulty with the EH is represented by the effective prediction of short-term rates. We discuss the relevance of these findings for central banks’ use of forward guidance.