Taylor Rules and the Term Structure

The expectations model of the term structure has been subjected to numerous empirical tests and almost invariably rejected, with the failure generally attributed to systematic expectations errors or to shifts in risk premia.Rules for monetary policy designed along the lines of Taylor (1993) specify that the central bank adjusts short-term yields in response to deviations of inflation and output gaps from target level. Such rules give a good empirical account of the behavior of the short-term interest rate.Combining the Taylor rule and expectations theory, it is possible to generate ---along lines pioneered by Campbell and Shiller (1987) --- a series of theoretical long-term interest rates. When such theoretical rates are calculated for the U.S. over 1980 to 2004, considerable support for the expectations theory emerges.