A defence of the expectations theory as a model of us long-term interest rates
BIS Working Papers
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No
85
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03 January 2000
This paper re-examines the empirical content of the expectations theory of the
term structure by employing the Campbell-Shiller (1987) methodology to study
the behaviour of 10-year/three-month US government yield spreads. The
methodology is implemented in two ways. First, theoretical spreads satisfying
the expectations theory are constructed from in-sample forecasts of future
changes in short rates generated from a small-scale VAR. Second, theoretical
spreads are computed from out-of-sample forecasts of changes in short rates
with the parameters of each VAR equation updated with a Bayesian procedure.
When the procedure is restricted to give less weight to new data than would be
the case with OLS estimation over an expanding sample, theoretical spreads
computed from out-of-sample forecasts track actual spreads closely in pre-1979
data. This is also the case as from the start of 1984 if data from the
1979Q4-1982Q4 period of non-borrowed reserve targeting are given zero weight
when estimating the parameters of the VAR.