The Expectations Hypothesis of the Term Structure of Interest Rates with Mean-reverting Expectations

Abstract: As it is the main theoretical explanation for how short term interest rates affect long-term interest rates, the expectations hypothesis of the term structure of interest rates is closely linked to the effectiveness of monetary policy. By assuming expectations about short term interest rates are mean reverting, this paper shows that monetary policy is most effective when expectations only slowly mean revert. Through analysis of interest rate data in the frequency domain, interest rates are shown to be mean reverting in various countries, implying that monetary policy in those countries is only partially effective.