Predictions of Short-Term Rates and the Expectations Hypothesis of the Term Structure of Interest Rates

Despite its important role in macroeconomics and finance, the expectations hypothesis (EH) of the term structure of interest rates has received little empirical support. While the EH’s poor performance has been attributed to a variety of sources, none appear to account for the EH’s poor performance. Recent evidence (Diebold and Li, 2003; Duffee, 2002; and Carriero, et al., 2003) suggests the possibility that the EH’s poor performance may be due to market participants’ relative inability to forecast the short-term rate. This possibility is investigated by comparing h-month ahead forecasts for the 1-month Treasury yield implied by the EH with the forecasts from both a random-walk model and a three factor model of the term structure. JEL Classification: E40, E52