Short-Term Interest Rates as Predictors of Inflation: On Testing the Hypothesis that the Real Rate of Interest is Constant

Abstract

In an innovative and provocative paper in this Review, Eugene Fama presents evidence which appears to be consistent with the joint hypothesis that the real rate of interest, ignoring taxes, is a constant and that the market for U.S. Treasury Bills is efficient in the sense of embodying rational expectations.' Those findings are strikingly at variance with a long list of previous studies which seemed to support the view that the real rate of interest varies over time and can be related to economic variables such as real output, monetary policy, and so forth.2 The methodologies which lead to these contradictory conclusions are quite different. Previous studies had followed the lead of Irving Fisher by relating nominal interest rates to distributed lags on past rates of inflation.3 These distributed lags are generally interpreted as approximations to the market's expected rate of inflation and thus any remaining variation is attributed to variation in the real rate.4 Fama's methodology, on the other hand, draws on the fact that the difference between the market interest rate and the subsequently observed rate of inflation, the ex post real interest rate, consists by definition of the ex ante real interest rate plus a pure forecasting error.5 The hypothesis of market efficiency implies that these forecasting errors must be serially random. Thus, observing ex post real rates is equivalent to observing ex ante real rates with random measurement error. These errors of course confound the problem of identifying variation in the ex ante real rate. In this paper, we will argue that the relative magnitude of these measurement errors is such that the tests carried out by Fama were not powerful enough to reject the joint hypothesis that the ex ante real rate is a constant and expectations are rational. More powerful tests which are presented in this paper using the same data do lead to rejection of that hypothesis. Of course, rejection

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