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The Rational Expectations Hypothesis of the Term Structure, Monetary Policy, and Time-Varying Term Premia

Most empirical studies of the rational expectations hypothesis of the term structure (REHTS) generally find that the data offer little support for the theory.(1) In many cases this large body of empirical work indicates that the theory does not even provide a close approximation of market behavior. This feature has led some investigators to search for alternative "irrational" theories of behavior in order to explain the data. We, on the other hand, believe that the rejections are so striking that the large amount of irrationality implied by the data is too implausible for this avenue to be treated seriously. Since the rejection of rational expectations in these studies generally involves the rejection of more complicated joint hypotheses, we choose to focus our energies on exploring a broader class of models that are consistent with REHTS. In particular, we examine a model that incorporates Federal Reserve behavior along with a reasonable parameterization of term premia to revise the theory. The consideration of Fed behavior was first suggested by Mankiw and Miron (1986), who found that REHTS was more consistent with the data prior to the founding of the Fed. Even stronger evidence is presented in Choi and Wohar (1991), who cannot reject REHTS over the sample period of 1910-14. Cook and Hahn (1990) and Goodfriend (1991) argue persuasively that the Federal Reserve's use of a funds rate instrument, and, in particular, the way in which that instrument is employed, is partly responsible for the apparent failure of REHTS. Recently Rudebusch (1994), in a study very much in the spirit of ours, provides some empirical support for the Cook and Hahn (1990) and Goodfriend (1991) hypothesis. Further, McCallum (1994) shows the theoretical linkage between the Fed's policy rule and the regression estimates in various tests of REHTS when the Fed responds to the behavior of longer-term interest rates. While Fed behavior represents a potentially important component for explaining the empirical results of tests of REHTS, any explanation of these results that also maintains rational expectations must include time-varying term premia. Without time-varying term premia, tests of REHTS will not be rejected. This fact is pointed out in Mankiw and Miron (1986) and Campbell and Shiller (1991). Further, Campbell and Shiller indicate that white-noise term premia are insufficient to reconcile theory with data. We find this to be the case as well. Thus, we examine a more elaborate model of term premia coupled with Fed behavior in an attempt to explain some of the empirical results on REHTS. Before developing a theory of Fed behavior and linking it to empirical work on REHTS, we present, in Section 1, a brief overview of the rational expectations hypothesis of the term structure. Then, in Section 2, we construct a model of Fed behavior that emodies the key elements described in Goodfriend (1991). We use the resulting model along with REHTS to generate returns on bonds of maturities ranging from one to six months. In Section 3 we focus, in essence, on the empirical regularities documented by Roberds, Runkle, and Whiteman (1993). We show that Fed behavior is not enough to reproduce their findings. Then, in Section 4, we turn our attention to incorporating a more realistic behavior of term premia. Combining these term premia with rational investor and Fed behavior generates data that is roughly consistent with the Roberds, Runkle, and Whiteman results. Section 5 concludes. 1. THE RATIONAL EXPECTATIONS THEORY OF THE TERM STRUCTURE Tests and descriptions of the rational expectations theory of the term structure constitute a voluminous literature. An excellent survey can be found in Cook and Hahn (1990), and an exhaustive treatment is contained in Campbell and Shiller (1991). The basic idea is that with the exception of a term premium, there should be no expected difference in the returns from holding a long-term bond or rolling over a sequence of short-term bonds. …