The New York Fed has published a staff report by Richard K. Crump, Stefano Eusepi, and Emanuel Moench titled Is There Hope for the Expectations Hypothesis?:
Most macroeconomic models impose a tight link between expected future short rates and the term structure of interest rates via the expectations hypothesis (EH). While the EH has been systematically rejected in the data, existing work evaluating the EH generally assumes either full-information rational expectations or stationarity of beliefs, or both. As such, these analyses are ill-equipped to refute the EH when these assumptions fail to hold, fueling hopes for a “resurrection” of the EH. We introduce a model of expectations formation which features time-varying means and accommodates deviations from rationality. This model tightly matches the entire joint term structure of expectations for output growth, inflation, and the short-term interest rate from all surveys of professional forecasters in the U.S. We show that deviations from rationality and drifting long-run beliefs consistent with observed measures of expectations, while sizable, do not come close to bridging the gap between the term structure of expectations and the term structure of interest rates. Not only is the EH decisively rejected in the data, but model-implied short-rate expectations generally display, at best, only a weak co-movement with the forward rates of corresponding maturities.
The Expectations Hypothesis is something of a hobby horse of mine and I welcome yet another debunking! But My God, it’s just like technical analysis! It seems so plausible and magic when you first read about it and there are hordes of evangelists touting its efficacy!
Far from resurrecting the EH, the tight connection between short-term interest rate expectations and the term structure of interest rates, assumed to hold in theory, demonstrably fails to hold in practice. Expected interest rates beyond two years have, at best, only a weak co-movement with forward rates of the corresponding maturities. In fact, the correlation between changes in longer-term forward rates out to ten years and corresponding longer-horizon short rate forecasts converges towards zero as the maturity increases. In light of this evidence, it is unsurprising that formal tests in the spirit of Froot (1989) using our model-implied expectations result in decisive rejections of the EH. Importantly, these tests do not require any assumption about the expectations formation mechanism.
The flip side of our results is that the wedge between observed yields and expected future short-term interest rates captures the vast majority of yield variability at medium and long maturities. In models where agents are risk averse, this wedge represents time-varying compensation for bearing risk. However, using linear regressions we show that this wedge is only partially explained by the underlying factors shaping beliefs about the state of the economy. This implies that any model designed to explain both the term structure of short rate expectations and the term structure of interest rates would need to involve additional drivers
They conclude:
In this paper, we reevaluate the empirical evidence regarding the EH by proposing a model of expectations formation that allows for deviations from [full information rational expectations] and accounts for time-varying beliefs about the long-run. This class of models has shown promise to bridge the gap between EH-implied and observed yields, fueling hopes for a “resurrection” of EH. We estimate the model using the universe of consensus forecasts from all U.S. surveys of professional forecasters covering more than 600 survey-horizon pairs at a monthly frequency. While model-implied short-rate expectations move considerably at all horizons and suggest significant departures from rational expectations, they do not come close to matching the observed term structure of interest rates. Instead, the EH-implied short-rate expectations generally display, at best, only a weak co-movement with the forward rates of corresponding maturities. Not surprisingly, formal tests of the EH are soundly rejected.
These results suggest alternative explanations for the behavior of observed bond yields such as heterogenous beliefs, financial market frictions, nonstandard risk preferences and behavioral theories of asset pricing. Accommodating such features in models of equilibrium bond prices can have important implications for macroeconomic models, including in the transmission mechanism of monetary policy. In standard models, used by both academics and policymakers, the monetary transmission channel is based solely on the EH. The central bank can exert a tight control on longer-term interest rates by responding to changing economic conditions in a systematic manner, i.e. adhering to time-invariant policy rules, or by communicating directly about likely future policy moves through forward guidance. The sizable deviation of observed interest rates from the EH, which we document, calls in to question this conventional framework.