An experimental investigation of the term structure of interest rates

1. An experimental investigation of the term structure of interest rates James Watson School of Economics, University of East Anglia

2. An experimental investigation of the term structure of interest rates • Introduction • The term structure of interest rates • Macroeconomic experiments • Experimental design • Experimental results • Conclusions

3. Introduction • Policymakers set short term nominal interest rates • Main instrument of modern monetary policy • Long term interest rates are anchored to the return on long term government bonds • Private sector investment, personal mortgages and refinancing government debt depend on longer term interest rates

4. Introduction • The price of government bonds is determined by the market • Policymakers control the short rate but want to control the long rate • Understanding the link between the two is crucial for policy • This is the term structure of interest rates

5. The term structure of interest rates • The yield on a government bond is the annualised return to maturity • A 2-year UK treasury bond matures for £100 • If you were to buy one for £90.70 you are guaranteed a 5% return (or yield) on your investment (unless UK plc goes bust of course!

6. The term structure of interest rates • If you thought a certain 5% return on your money over the next two years was good (!) you would buy these bonds – as would everybody else… • Clearly demand is driven by the certain return you might expect to get elsewhere • The term structure of interest rates (or yield curve) is the line connecting yields of differing maturities. Long interest rates are anchored to the term structure

7. The term structure of interest rates • The upward slope suggests an expectation that interest rates will increase • This is the expectations hypothesis of the term structure • An upward slope is also thought to represent a risk averse attitude to the future – a premium for holding a risky asset

8. The term structure of interest rates • The expectations hypothesis says: • The short interest rate should predict the long interest rate up to some risk premium • For an excellent review of theory, testing and some empirical results see Cuthbertson & Nitzche (2004)

9. The term structure of interest rates • Could a clear policy objective flatten the term structure? • Does it help if the policymaker is trustworthy? • UK inflation target 1992- • Formal BoE independence 1997-

10. The term structure of interest rates • Mixed results: the term structure must be governed by arbitrage plus risk. This has proved difficult to observe empirically… • Time-varying risk, monetary policy regime, global economic shocks, cross-country variation, causality, non-stationarity of data • For a review see Campbell (1995) and Kozicki and Tinsley (2001)

11. Macroeconomic experiments • The laboratory can control for these confounds • Test a theory in the laboratory • Does the laboratory approximate the real world? • Testing policy: it’s difficult to experiment on the real economy • For surveys see Duffy (2008), Ricciuti (2005)

12. Experimental design • Does a trustworthy policymaker have more control over the term structure? • Does it matter if signals about the future are more (or less) accurate?

13. Experimental design • 5 subjects participate in a simple 2-period economy • Buy and/or sell bonds to alter the ratio of cash to bonds held via an interactive computerised auction programmed in z-Tree • Value of cash is certain, value of bonds depends on the future state of the world – this implies a 2-period term structure • Subjects participate in 15 independent rounds and are paid according to their performance in one randomly selected round

14. Experimental design • Two policymakers: • Inflation targeter: trustworthy, expect high inflation get high interest rates • Second policymaker cares about inflation and output: policy response is more uncertain

15. Experimental design • Subjects receive signals about future output & future inflation • Subjects face one policymaker with either low noise or high noise signals • 4 treatments • 2-by-2 design

16. Experimental design • Subjects receive information about their policymaker type • Statement of intent: • To deliver stable inflation • To deliver a steady increase in production and deliver stable inflation • Examples of previous policy decisions

17. Experimental design • Predictions: • Increasing policy uncertainty increases the risk premium • Increasing risk increases the risk premium

18. Experimental results • Is testing the term structure in the laboratory viable? • Subjects seemed to understand the environment. In all treatments except B4 the term structure contains statistically significant information about the path of the short interest rate • The expectations hypothesis does significantly better with an inflation targeter than with policy uncertainty

19. Experimental results • Between treatment differences are not as predicted • No statistically significant difference between risk premia • The difference is in the informational content of the term structure • The ‘A’ policymaker has more control over the term structure

20. Experimental results • Subjects make significant use of the previous rounds trade prices in all 4 treatments • As policy uncertainty increase subjects rely more on the past • In treatment ‘B4’ subjects make no significant use of signals about the future

21. Experimental results • Statistically significant differences between policymakers • More risk leads to a significant change in behaviour • The effects are direction theoretically predicted, but empirically are unexpected

22. Conclusions • Overall positive from the perspective of testing the term structure in the laboratory • Policy uncertainty leads to less control of the term structure or conversely, the term structure is less useful as a predictor of the short rate • Evidence that increased policy uncertainty significantly changes behaviour, but not in the way theory predicts • A possible insight into why the empirical results are mixed

23. Appendix: Expectations hypothesis • More trade in uncertain ‘B’ treatments. Wilcoxon tests: p-values < 0.01 • Expectation Hypotheses: Results from multi-level restricted maximum likelihood regression *,**,*** indicate significance at 10%, 5% and 1% levels respectively

24. Appendix: Adaptive expectations • What does the long rate depend on? Results from multi-level restricted maximum likelihood regression *,**,*** indicate significance at 10%, 5% and 1% levels respectively

25. Appendix: Experimental term structures

26. Appendix: Policy rule and noise • Policy via Taylor Rule • Treatment ‘A’: ρ = 1 • Treatment ‘B’: ρ = 0.5 • Treatment ‘2’: Noise ~ N[0,4] • Treatment ‘4’: Noise ~ N[0,16]

27. References Campbell, John Y. 1995. “Some lessons from the yield curve.”, Journal of Economic Perspectives, 9: 129-152 Cuthbertson, Keith, and Dirk Nitzche. 2004. Quantitative Financial Economics. Wiley Duffy, John. 2008. “Macroeconomics: A Survey of Laboratory Research.” Working Paper 334, University of Pittsburgh, Dept. of Economics, downloadable at http://www.econ.pitt.edu/papers/John_hee11.pdf Fischbacher, Urs. 2007. “z-Tree: Zurich toolbox for ready made economic experiments.” Experimental Economics, 10: 171-178 Kozicki, Sharon, and Peter Tinley. 2001. “Shifting endpoints in the term structure of interest rates.” Journal of Monetary Economics, 47: 613-652 Ricciuti, Roberto. 2008. “Bringing macroeconomics into the lab.” Journal of Macroeconomics, Elselvier, 30(1): 216-237