Working Paper

What do you expect? : imperfect policy credibility and tests of the expectations hypothesis?

Abstract: The expectations hypothesis is a theory of the term structure of interest rates that describes a conventional view of the transmission mechanism of monetary policy. According to the expectations hypothesis, bond rates are related to current and expected movements in the policy-controlled rate. However, empirical rejections of the expectations hypothesis are commonplace and lead many to question this description of policy transmission. This paper argues that failure to account for imperfect policy credibility may explain empirical rejections. Empirical rejections may occur even when changing anticipations of future short rates are the primary source of variation in bond rates and the standard term structure transmission channel remains valid.

Keywords: Rational expectations (Economic theory); Inflation (Finance);

Bibliographic Information

Provider: Federal Reserve Bank of Kansas City

Part of Series: Research Working Paper

Publication Date: 2001

Number: RWP 01-02