Table 3 lists recent empirical studies that use fundamental determinants along with the federal funds rate or some other short rate
. If the Federal Reserve dominates movements of the federal funds rate and of other short-term rates, the effect of short rates
on long rates reflects monetary policy influence on long rates.
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
The two specific series that we employ have been compiled by Ibbotson (2002) and pertain to the 30-day T-bill yield for the short rate
and the long-term yield on a bond of roughly twenty years to maturity for the long rate.
Ang and Bekaert ask whether stock returns in France, Germany, Japan, the United Kingdom, and the United States are predictable by three instruments: the dividend yield, the earnings yield, and the short rate
. The predictability regression is suggested by a present value model with earnings growth, payout ratios, and the short rate
as state variables.
The second point in the comment is that my assertion in the paper that rising long rates (given an unchanged short rate
) are expansionary is incorrect.
The Johansen approach provides a test of the assertion that the same common stochastic trend (the expected future short rate
) underlies the behaviour of each longer yield.(5) One difference between the Johansen approach and the single-equation estimator of Phillips and Hansen is that the results of the former will be independent of normalisation, as the procedure yields to an estimate of the cointegration vector using information from a VAR which includes all the variables of interest, whilst the latter essentially applies a semi-parametric correction to the standard Engle and Granger (1987) OLS estimator.
In addressing these issues, it is useful to divide the yield on a long-term bond into an expected-rate component that reflects the anticipated average future short rate
for the maturity of the bond and a term-premium component that reflects the compensation that investors require for bearing the interest rate risk from holding long-term instead of short-term debt.
Put differently, the spread (difference) between any given long rate and a short rate
is usually positive.
The persistence of short-term interest rates is important because it affects the forecastability of short-term rates and thus the effect of changes in the short rate
on long rates.
and Dai and Singleton explore more complicated multifactor models in which the level, long-run mean, and volatility of the short rate
can move independently.
The Fed also promised to keep the short rate
low for a long period of time, causing long-term rates to remain low as well.
The LPT relies upon expected short rates
, which are defined in the short rate