The Expectations Theory and the Founding of the Fed: Another Look at the Evidence

One of the most influential contributions to the literature on the expectations theory of the term structure of interest rates is Mankiw and Miron (1986), who found support for the expectations theory prior to the founding of the Fed but not after. Mankiw and Miron suggested that the failure of the expectations theory after the Fed’s founding was due to the Fed’s practice of smoothing short-term interest rates. In this paper we show that Mankiw and Miron’s findings are the result of a bias in the test that they employ. This bias arises when the short-term rate is excessively volatile, as it was during the financial panic of 1907. We argue that our finding that there was no more evidence supporting the expectations theory before the Fed’s founding than after is consistent with the Fed’s limited activity during its formative years. We argue that it is unlikely that the Fed actually pursued a policy of smoothing interest rates during the early years of its existence. But, even if it had, we argue that it is unlikely that such a policy accounts for the marked change in the behavior of interest rates. JEL Classification: E40, E52