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Business cycles and the expectations of short-term central bank rates in light of Construal Level Theory

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  • Sagi Akron

    (University of Haifa)

Abstract

Capital market investors’ capability to forecast the central bank interest rate is critical, since the latter serves as an anchor for many economic transactions. Financial-economics literature shows that the short-term forward rate is a crucial factor considered by investors in the expectation of central bank returns. Yet, it is unclear if the forward rate, a rather abstract measure, is a sufficient predictor—whether a more concrete variable, such as investors’ crisis cycle perceptions, significantly adds explanatory power to the central bank rate expectations. We examine Israeli capital market forecasting of the short-term Central Bank of Israel interest rate, i.e., a 1-to-3-month horizon, during the period 1993–2008. Beyond extracting the forward rate, we create a proxy for crisis business cycle, using local and international capital market performance. This financial setting allows us to examine the Construal Level Theory, where the abstract variable is the forward rate, the concrete variable is the economic crisis, and the construal level is the horizon length. The findings strongly support Construal Level Theory. We show that the expected central bank rate’s reliance on the abstract forward rate becomes more aggressive for longer periods. In addition, the significant positive impact of the economy’s crisis cycle on the short-horizon expected federal fund diminishes in longer horizons. Hence, there is a forecasting substitution effect between the concrete economy crisis and the abstract forward rate in the psychological distance represented by the investment horizon.

Suggested Citation

  • Sagi Akron, 2016. "Business cycles and the expectations of short-term central bank rates in light of Construal Level Theory," Eurasian Business Review, Springer;Eurasia Business and Economics Society, vol. 6(2), pages 171-187, August.
  • Handle: RePEc:spr:eurasi:v:6:y:2016:i:2:d:10.1007_s40821-016-0043-7
    DOI: 10.1007/s40821-016-0043-7
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    References listed on IDEAS

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    1. Simon, David P, 1990. "Expectations and the Treasury Bill-Federal Funds Rate Spread over Recent Monetary Policy Regimes," Journal of Finance, American Finance Association, vol. 45(2), pages 467-477, June.
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    3. Simon, David P, 1989. "The Rationality of Federal Funds Rate Expectations: Evidence from a Survey: A Note," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 21(3), pages 388-393, August.
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    More about this item

    Keywords

    Central bank interest rate; Capital market forecasting; Business crisis; Construal Level Theory;
    All these keywords.

    JEL classification:

    • E47 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Forecasting and Simulation: Models and Applications
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • G02 - Financial Economics - - General - - - Behavioral Finance: Underlying Principles

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