One explanation for this difference is that the short rate
can be what is called "mean-reverting," i.
During a press conference, Fed Chairman Bernanke re-emphasized that the economic data will be driving the Fed's decisions ahead, both on "taper" and on short rate
This equivalently means that the difference between the long rate and short rate
is the sum of a weighted average of expected changes in future short rates
and a function of the risk premium.
What our analysis missed a generation ago was that the typical model with only one interest rate could not possibly allow for stabilizing market responses in long rates when the central bank set the short rate
On the other hand, linearity cannot be rejected for the error-correction model with M0 and the short rate
That result demonstrates, I would suggest, not only that the usual regression test is inappropriate but also that it is misleading to think of the expectations theory in terms of the "predictive content" of the spread for future changes of the short rate
They take a one-month maturity for the short rate
and a three-month maturity for the long rate and consider the period October 1987 to November 1995.
Table 3 lists recent empirical studies that use fundamental determinants along with the federal funds rate or some other short rate
A general assumption that the slope of the yield curve flattens, implying low inflation expectations, means that in 1995 the long interest rate will be on the same level as the short rate
in the difference between the current short rate
and the stochastic trend.
The predictability regression is suggested by a present value model with earnings growth, payout ratios, and the short rate
as state variables.
Indeed, if the short rate
in the yield spread is the fed funds rate - as it is in the new component of the index of leading indicators - movements in the short rate
are more likely to follow movements in the long rate if there is a difference in timing.