Long-Term Interest Rates and Inflation: A Fisherian Approach

I n recent years, Federal Reserve (Fed) policymakers have come to rely on long-term bond yields to measure the public’s long-term inflationary expectations. The long-term bond rate plays a central role in Goodfriend’s (1993) narrative account of Fed behavior, 1979–1992, which links policyrelated movements in the federal funds rate to changes in the yield on long-term U.S. Treasury bonds. According to Goodfriend, Fed officials interpreted rapid increases in long-term bond rates as the product of rising inflationary expectations, reflecting a deterioration in the credibility of their fight against inflation. To restore that credibility, they responded by tightening monetary policy, that is, by raising the federal funds rate. Mehra (1995) presents statistical results that support Goodfriend’s view. Using an econometric model, he demonstrates that changes in long-term bond rates help explain movements in the federal funds rate during the 1980s. While these studies provide convincing evidence of a link between Fed policy and long-term bond rates, both start with the untested hypothesis that movements in such rates primarily reflect changes in long-term inflationary expectations. And while economic theory does identify expected inflation as one determinant of nominal bond yields, it suggests that there are other determinants as well. Using theory as a guide, this article seeks to measure the contribution each determinant makes in accounting for movements in longterm bond yields. By doing so, it attempts to judge the extent to which Fed policymakers are justified in using these bond yields as indicators of inflationary expectations.