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

  • Daniel L. Thornton

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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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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