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Modeling long-term nominal interest rates

  • Jeffrey C. Fuhrer

The Pure Expectations Hypothesis has long served as the preeminent benchmark model of the relationship between the yields on bonds of different maturities. When coupled with rational expectations, however, most empirical renderings of the model fail miserably. This paper explores the possibility that failure to account for changes in market participants' assessment of the monetary policy regime, including changes in the target rate of inflation and the response to inflation and output, may explain much of the failure of the PEH. Estimating explicit expectations for changing monetary policy regimes in conjunction with the PEH model goes a long way toward rescuing the PEH model. The long rate implied by the PEH for a stationary short rate process tracks the observed long rate. The predicted spread between the long and the short rate is highly correlated with the actual spread. The standard deviation of the theoretical spread is nearly identical to that of the actual spread. Overall, these results cast suspicion on the use of spread regressions to test the PEH.

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Paper provided by Federal Reserve Bank of Boston in its series Working Papers with number 95-7.

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Date of creation: 1995
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Publication status: Published in Quarterly Journal of Economics, no. 111 (November 1996): 1183-1209
Handle: RePEc:fip:fedbwp:95-7
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  1. Shiller, Robert & Campbell, John, 1991. "Yield Spreads and Interest Rate Movements: A Bird's Eye View," Scholarly Articles 3221490, Harvard University Department of Economics.
  2. Perron, P, 1988. "The Great Crash, The Oil Price Shock And The Unit Root Hypothesis," Papers 338, Princeton, Department of Economics - Econometric Research Program.
  3. Shiller, Robert J, 1979. "The Volatility of Long-Term Interest Rates and Expectations Models of the Term Structure," Journal of Political Economy, University of Chicago Press, vol. 87(6), pages 1190-1219, December.
  4. John Y. Campbell & Robert J. Shiller, 1986. "Cointegration and Tests of Present Value Models," NBER Working Papers 1885, National Bureau of Economic Research, Inc.
  5. Campbell, J.Y. & Ammer, J., 1991. "What Moves The Stock And Bond Markets? A Variance Decomposition For Long- Term Asset Returns," Papers 127, Princeton, Department of Economics - Financial Research Center.
  6. Michael Dotsey & Christopher Otrok, 1995. "The rational expectations hypothesis of the term structure, monetary policy, and time-varying term premia," Economic Quarterly, Federal Reserve Bank of Richmond, issue Win, pages 65-81.
  7. Hamilton, James D., 1988. "Rational-expectations econometric analysis of changes in regime : An investigation of the term structure of interest rates," Journal of Economic Dynamics and Control, Elsevier, vol. 12(2-3), pages 385-423.
  8. Campbell, John, 1995. "Some Lessons from the Yield Curve," Scholarly Articles 3163264, Harvard University Department of Economics.
  9. Marvin Goodfriend, 1993. "Interest rate policy and the inflation scare problem: 1979-1992," Economic Quarterly, Federal Reserve Bank of Richmond, issue Win, pages 1-24.
  10. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  11. Rudebusch, Glenn D., 1995. "Federal Reserve interest rate targeting, rational expectations, and the term structure," Journal of Monetary Economics, Elsevier, vol. 35(2), pages 245-274, April.
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