Is There Hope for the Expectations Hypothesis?

Most macroeconomic models impose a tight link between the term structure of interest rates and expected future short rates via the expectations hypothesis (EH). While systematically rejected in the data, existing tests of the EH typically assume full information rational expectations, stationarity of beliefs, or both. As such, they are ill-equipped to refute the EH when these assumptions fail to hold, leaving the door open for a “resurrection.” We re-evaluate the EH using direct measures of expected short rates from all available U.S. surveys of professional forecasters, combined with a parsimonious model of expectations formation to construct the term structure of expectations. We show that deviations from rationality and time variation in long-run beliefs consistent with the observed survey data, while sizable, do not come close to bridging the gap between the term structure of expectations and the term structure of interest rates. We introduce a novel test of the EH and show that the EH is decisively rejected in the data. Outside of short maturities, expectations display, at best, only a weak co-movement with the forward rates of corresponding maturities, both unconditionally and in response to a monetary policy shock.