Alternative Tests of the Expectations Hypothesis of the Term Structure of Interest Rates

Similar to the US Federal Reserve and the European Central Bank, most central banks use the day-to-day interest rate on the inter-bank money market as their operational target. Using modern monetary instruments central banks can control very short-term interest rates. However, the problem is that the real economy (e.g. investment and consumption) and inflation, will generally be affected by the long-term interest rate. Central banks are unable to control the long-term interest rate. Therefore in order to analyse how monetary policy will affect the real economy, we need to know the relationship between short-term interest rates and long-term interest rates, referred to as the term structure of interest rates. Given the importance of knowing how this mechanism works, it is not surprising that this topic has become a highly important area of research and this is likely to continue to be the case now that the exchange rate channel does not exist in the Euro area. What is required is a theory, which will link interest rates of different maturities. The expectations hypothesis (EH) of the term structure of interest rates states that long-term interest rates depend entirely on expected future short-term interest rates. Hence the interest rate on a long-term bond (a debt instrument) will equal the average of short-term interest rates that people expect to occur over the life of the bond. This is referred to as the pure expectations hypothesis (PEH) and assumes there is no added risk to holding a longer maturity bond as opposed to a series of shorter maturity bonds, in other words the risk (term) premium is zero. It is the main theory behind the analysis of the link between interest rates of different maturities and hence is of crucial importance in understanding the impact of monetary policy on the real economy, referred to as the transmission mechanism of monetary policy. Although the evidence using European data is very supportive of the EH, for interest rates at the short end of the maturity spectrum (i.e. less than 12 months), the central bank’s influence on interest rates declines as the maturities become longer. There are two possible reasons why the EH may be rejected. The first is the impact of a time varying risk premium. If agents perceive large (unpredictable) changes in short rates as a result of inflation or general uncertainty, then this will lead to rejections of the EH. The second possible reason is of a more statistical nature. The tests used may lead to false rejections of the EH because of their poor properties in finite samples. It is specifically these issues that are the main focus of this study, where we analyse the small sample properties using a number of Monte Carlo (MC) experiments. The experiments focus on the fact that the alternative single equation tests based on the regression of the change in the short-term rate on the lagged spread are prone to severe over-rejection of the EH, even when it is true. However tests of the spread on the first difference of the short-rate reject at the correct rate. We find using MC experiments that this is in fact the case and these findings are consistent with those using US data.