Expectations and the Term Structure of Interest Rates: Evidence and Implications

I nterest rates on long-term bonds are widely viewed as important for many economic decisions, notably business plant and equipment investment expenditures and household purchases of homes and automobiles. Consequently, macroeconomists have extensively studied the term structure of interest rates. For monetary policy analysis this is a crucial topic, as it concerns the link between short-term interest rates, which are heavily affected by central bank decisions, and long-term rates. The dominant explanation of the relationship between shortand longterm interest rates is the expectations theory, which suggests that long rates are entirely governed by the expected future path of short-term interest rates. While this theory has strong implications that have been rejected in many studies, it nonetheless seems to contain important elements of truth. Therefore, many central bankers and other practitioners of monetary policy continue to apply it as an admittedly imperfect yet useful benchmark. In this article, we work to quantify both the dimensions along which the expectations theory succeeds in describing the link between expectations and the term structure and those along which it does not, thus providing a better sense of the utility of this benchmark. Following Sargent (1979) and Campbell and Shiller (1987), we focus on linear versions of the expectations theory and linear forecasting models of