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. Discretion versus policy rules in practice. Carnegie-Rochester Conference Series on Public Policy 39, 195-214] 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. Cointegration and tests of present value models. Journal of Political Economy 95, 1062-1088]—a series of theoretical long-term interest rates. When such theoretical rates are calculated for the US over 1980-2004, considerable support for the expectations theory emerges.