How are predictions related to market expectations of the economy?
A. One of the most pervasive theories of the determinants of the yield curve is the expectations hypothesis, which posits that long-term interest rates are averages of expected future short-term rates. In the “pure” version of the hypothesis, this is the whole story. That version has been repeatedly rejected in econometric tests [see Campbell (1995)], so it is likely that there are other important determinants as well, such as risk or liquidity premiums. Nevertheless, it is difficult to dispute that interest rate expectations play an important role, and that those expectations are related to future real demand for credit and to future inflation. A rise in short-term interest rates induced by monetary policy may lead to a future slowdown in real economic activity and demand for credit, putting downward pressure on future real interest rates. At the same time, slowing activity may result in lower expected inflation. By the expectations hypothesis, these expected declines in future short-
