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May 30, 2006
The Expectations Hypothesis
The Expectations Hypothesis is one possible linkage between short-term interest rates and long-term interest rates. If future interest rates are largely determined by future inflation, then the long-term bond market is going to be sensitive to forecasts of future inflation.
A handout from today's WSJ illustrated this concern.
Calculating the forward rate is another view of this issue.
The equations for the expectations hypothesis and the forward rate are very closely related. The forward rate is not necessarily equal to the expected future rate because an unobservable risk premium is also a component of the long-term rate.
Posted by bparke at May 30, 2006 09:55 PM