Interest Rate Expectations Versus Forward Rates: Evidence From an Expectations Survey

Abstract

11], economists have developed a substantial literature relating the forward interest rates implied by currently prevailing rates on debts of differing maturity to market participants' expectations of interest rates in the future.Hicks suggested that implied forward rates might differ from the corresponding expected future rates by a liquidity premium, or term premium, and more recently Stiglitz [19] and others have formalized how market partici- pants' risk aversion would give rise to such a premium.While in principle the premium could be either positive or negative, the usual upward slope of the yield curve suggests a positive premium that itself varies positively with the debt's term to maturity.Kessel [10] subsequently suggested that the premium for a given maturity might vary with real economic activity, and Culbertson [2] argued that relative outside debt supply quantities should als' affect the premium.More recently Nelson [16] offered an explanation for the premium even in the absence of risk aversion, and Friedman [5] related changes in the premium to shifts in wealth ownership among heterogenous investors.An accompanying empirical literature has repeatedly tested each of these various hypotheses about forward rates and expected future rates, but usually with somewhat inconclusive results.A key reason for the weakness of much of this empirical literature has been the absence of independent information about market participants' expectations.Not surprisingly, the very early attempts based on the assumption of perfect foresight were most unsuccessful and this approach quickly went out of fashion.The traditional procedure since then has been either to apply the Hicks-Lutz theory to derive expectations proxies from the same term-structure data that generate the forward rates, or to use some other device like autoregressive or 'rational' expectations proxies.In either case, any hypoth- esis submitted to statistical testing is necessarily a joint hypothesis embodying both the relation of forward rates to expectations and the formation of expecta- tions themselves.Failure of the hypothesis to conform to the data may then indicate rejection of the proposition relating forward rates to expectations, or rejection of the identifying restrictions imposed to derive the expectations proxy (or both).The object of this paper is to test several familiar hypotheses about the relationship between the forward rates implied by the term structure and interest

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