Academic journal article Federal Reserve Bank of St. Louis Review

Testing the Expectations Hypothesis: Some New Evidence for Japan

Academic journal article Federal Reserve Bank of St. Louis Review

Testing the Expectations Hypothesis: Some New Evidence for Japan

Article excerpt


Spending decisions, especially investment decisions, are largely determined by long-term interest rates, while the actions of the monetary authority have a direct effect on interest rates only at the very short end of the yield curve. An important question in monetary economics and finance is, How do the actions of the monetary authority get translated along the entire yield curve? In countries where a wide variety of bonds with different maturities are traded, policy actions are thought to be translated from the short end to the long end of the term structure in accordance with the expectations hypothesis (EH), which asserts that the long-term rate is equal to market participants' expectation of the short-term rate over the holding period of the long-term asset plus a constant risk premium.

Until the mid-1980s, the Japanese bond market was relatively small, illiquid, and tightly regulated. Japan's capital markets were segmented by government regulations, not the public's preferences. Arbitrage opportunities across maturities were limited. Few thought that the EH applied to Japan. consequently, there was no reason to test the EH for Japan. Monetary policy was thought to affect lending through quantity constraints and not through interest rates.

The Japanese began to deregulate their bond market in the 1970s. The structural changes in the Japanese financial markets have generated considerable interest in testing the EH using Japanese data (e.g., Campbell and Hamao, 1993; Singleton, 1990; Shirakawa, 1987; and Shikano, 1985). This paper is an extension of this research agenda, but differs from the previous literature in two respects. First, this paper investigates the EH by estimating a bivariate vector autoregression (VAR) for the long-term and short-term interest rates and testing the restrictions implied by the EH. This test was first suggested by Campbell and Shiller (1987); however, the procedure used here was developed by Bekaert and Hodrick (2001). (1)

Second, this paper deals directly with the issue of stationarity. While stationarity is frequently considered in testing the EH, its implications for the EH are seldom discussed. This paper attempts to fill this void. As a matter of theory, many economists and financial specialists appear to believe that interest rates are stationary. If they are not, the role played by the EH in monetary policy may be diminished.

As a practical matter, interest rates tend to exhibit considerable persistence. Indeed, the null hypothesis of nonstationarity is frequently not rejected even in relatively large, finite samples. This is particularly important for Japanese interest rates because they exhibit considerable persistence at the monthly frequency. It is well known, however, that tests of unit roots may have low power. Moreover, many financial market economists argue that interest rates are stationary on theoretical grounds. Given the differences of opinion about whether interest rates are stationary in general, the VAR test is applied under the assumption that interest rates are either stationary or nonstationary. The issue of stationarity is important only if the conclusions concerning the EH differ markedly depending on the assumption made.

Japanese short-term interest rates, which began a rapid descent in late 1990, have hovered about their theoretical zero bound since mid- to late 1998. This feature of Japanese interest rates makes testing the EH after 1998 particularly difficult.

Section II discusses the evolution of Japanese financial markets during the postwar period and reviews the literature on tests of the EH in Japan in the postwar period. The data and some initial data analysis are presented in Section III. Section IV discusses nonstationarity and its implications for the EH. Some preliminary tests of the EH, which arise from the discussion in Section IV, are presented in Section V. In Section VI, the VAR test is applied to Japanese data under both assumptions--that interest rates are stationary or nonstationary, but cointegrated. …

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