International Finance Discussion Papers (IFDP)
October 2001 (Revised December 2003)
Evidence Uncovered: Long-Term Interest Rates, Monetary Policy, and the Expectations Theory
Abstract:
A large body of literature has failed to find conclusive evidence that the expectations theory of the term structure holds in U.S. data. This paper asks more narrowly whether the theory holds conditional on an exogenous change in monetary policy. We argue that previous work on the expectation theory has failed to sufficiently account for interactions between monetary policy and bond markets in the determination of long and short interest rates. Using methods that directly account for this interaction, we find strong evidence supporting a term structure channel for policy that is consistent with the expectations theory. We show that the marginal effect of our consideration for this source of simultaneity bias is significant in uncovering evidence for the theory. We also discuss previous claims that policy regime changes and short-term interest rate smoothing by the Fed accounts for the theory's unconditional failure in light of our findings.
Keywords: Term structure, vector autoregression, interest rate smoothing, policy regimes, Bayesian VAR
PDF: Full Paper
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