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It is commonly believed that while central banks closely control short-term interest rates, long-term interest rates, which are heavily influenced by expectations, play a more important role in affecting aggregate demand. Central banks thus face the problem of setting short-term interest rates in such a way as to move longer-term interest rates in the desired direction. A considerable amount of empirical evidence has been presented suggesting that the explanatory power of the expectations hypothesis may be greater than previously thought. Two findings, most likely interrelated, are of particular interest. First, it appears that the poor empirical performance of the expectations hypothesis may be due to the fact that short rates are typically difficult to predict, thus the theory may not be fundamentally flawed. Second, the expectations hypothesis appears to be better able to account for the behaviour of interest rates outside the United States. In case that the failure of the expectations hypothesis stems from the limited predictability of short rates, one would expect that further light can be shed on the expectations hypothesis by using data for a number of currencies with potential substantial differences in the time-series behaviour (and thus in the predictability) of short rates. In discussion paper No 1258, Research Fellow Stefan Gerlach and Research Affiliate Frank Smets explore this possibility by using one-, three-, six- and twelve-month Euro interest rates for a sample of 17 currencies and find that for all currencies the term spread does predict future movements in the short rate. Moreover, in a majority of cases they cannot reject the hypothesis that the estimated slope coefficient is different from unity as implied by the pure expectations theory. Finally, they show that the failure of the expectations theory to hold in a number of countries, most notably the United States, is due to a lack of predictability of the short-term rate which introduces a downward bias in the estimates in the presence of a time-varying term premium. They conclude that, despite the presence of a time-varying term premium, for many countries the expectations hypothesis is broadly compatible with the data. The Term Structure of Euro-Rates: Some Evidence in
Support of the Expectations Hypothesis |