The Expectations Hypothesis of the Term Structure for New Zealand

The Expectation Hypothesis of the Term Structure, henceforth EHTS 1 , is a fundamental building block of financial and macroeconomic theory. It has particularly important implications for understanding and predicting future movements in interest rates and for the conduct of monetary policy by central banks. The theory posits that the slope of the yield curve should reflect market expectations of future movements in interest rates. Perhaps one of the most influential papers that tests t he expectations hypothesis is Mankiw & Miron (1986), henceforth, MM. They found supportive evidence for the EHTS for the US before the founding of the Federal Reserve in 1914 but not after. According to MM, the founding of the Federal Reserve had led to a dramatic change in the behaviour of interest rates – it had significantly reduced the predictability of interest rates, thereby reducing the ability of the term spread to predict future changes in interest rates. I use similar econometric methodology as MM change in monetary operating procedure in March 1999 2 affected the behaviour of interest rates and thus the predictions underlying the expectations theory. To provide an understanding of the relationship between the expectations theory and the Reserve Bank's implementation of monetary p olicy, I will discuss a nd compare N ew Zealand's monetary operating procedure both before and after the introduction of the 1 I use 'EHTS' and 'expectations theory' interchangeably throughout this paper. 2 The Reserve Bank of New Zealand changed its monetary operating procedure with the introduction of the Official Cash Rate (OCR) system in March 1999. The regime change will be discussed in more details in Section 5. contrast to the founding of the Federal Reserve system in the US, the introduction of the OCR system in New Zealand in March 1999 had dramatically improved the predictability of short-term interest rates. My findings suggest that the EHTS holds for New Zealand for the OCR period, but not for the period preceding it. Kool & Thornton (2000) argued that the econometric methodology employed by MM tends to generate supportive results for the EHTS during periods when short-term interest rates are relatively more volatile than long-term interest rates. They also argued that the EHTS receives more support when the term spread is negative (inverted yield curve). Given that I follow MM's procedure in testing the EHTS, I will also examine Kool & Thornton's specification using New Zealand data to …