The Term Structure of Inflationary Expectations and Market Efficiency

Abstract

FISHER'S [15] ORIGINAL FORMULATION OF an equilibrium relationship in which a nominal interest rate is equal to a real rate of interest plus the expected rate of inflation has stimulated considerable interest and research. Although many empirical studies have utilized a single equation distributed lag specification1 of past price changes (which might be induced from a rational expectations argument) as a proxy for "expectations," T. F. Cargill and R. A. Meyer [5] have emphasized the necessity of a simultaneous equation structure if such distributed lags were to be employed. An alternative approach using Livingston's direct observations on expectations and allowing for the possibility of incomplete adjustment to expectations was employed by Cargill [2], W. Gibson [16] and D. Pyle [22]. These evolving improvements in conception of the empirical problem, data and econometric approach have led to a particularly interesting paper by K. Lahiri [18] in which S. Turnovsky's [25] expectations formation equations are coupled to the original Fisherian equation and then appropriate simultaneous equation techniques are applied to the resulting econometric relationships. From a slightly different perspective, E. Fama [13] has emphasized the implication for market efficiency embedded in the interest rate and expected inflation relationship. All analyses to date rest on the assumption that the real rate of interest is constant over time. Thus, as Fama noted, empirical implications for market efficiency tests really constitute a test of the joint hypothesis of efficiency and a constant rate.2 Despite the advances in conception of the empirical problem, data improvements, and improvements in econometric technique, the question of variation in the real rate of interest and the possibility of incomplete adjustment to changes in the real rate as well as to expected inflation leaves the extent and stability of the Fisherian relationship far from a settled matter. In addition, a much richer class of hypotheses emerges when Fama's emphasis on the market equilibrium aspects is carried further. No prior work has utilized any type of data to estimate the terni structure of expectations which is the key to Fisher's hypothesis when applied across maturities. In addition, the contributions of W. Sharpe [24] and J. Lintner [20] in providing an equilibrium capital asset pricing theory can be * The authors are professors,

The Postwar Stability of the Fisher Effect

“…Only PE12 and DGNP −1 remain statistically significant after the autocorrelation correction. This specification, which ignores supply shocks and taxes but includes liquidity and demand proxies, resembles recent empirical formulations (e.g., Carlson [9], Cargill and Meyer [8]). We present these results to facilitate comparison with our expanded model.…”

“…While this partially reconciled the conflicting theoretical and empirical evidence concerning the magnitude of the nominal interest rate response to anticipated inflation, important issues remained. One unsettling aspect of these studies was the volatility of the estimated response over various sample periods (see, for example, Cargill [4], Wachtel [24], Cargill and Meyer [7], [8], Levi and Makin [19], and Carlson [9]). In particular, Carlson [9], Cargill and Meyer [8], and Levi and Makin [19] each report estimates that drop, often dramatically, when the sample period is extended to include the first half of the 1970s.…”

“…One unsettling aspect of these studies was the volatility of the estimated response over various sample periods (see, for example, Cargill [4], Wachtel [24], Cargill and Meyer [7], [8], Levi and Makin [19], and Carlson [9]). In particular, Carlson [9], Cargill and Meyer [8], and Levi and Makin [19] each report estimates that drop, often dramatically, when the sample period is extended to include the first half of the 1970s. These results conflict with an explanation of the rise in that response during the 1960s based on a period of “learning” (for example, Cargill and Meyer [7]).…”

Capital Structure Theory and the Fisher Effect

“…The estimates reported vary substantially. Cargill and Meyer [2] report the high- est estimates of diD/d?r. However, their results are very sensitive to the periods selected and to their model specifications.…”

Separating short-term and long-term inflation expectations using observations from financial markets

“…These studies attempt to seek an answer to the question whether there is a general inflation expectations generating mechanism and how this process has changed over time. In the other approach, the term structure of inflation expectations has received some attention from economists concerned with the empirical testing of the Fisher equation, but until now only Cargill-Meyer (1980) have treated it in this context. Mullineaux (1980) and Tanzi (1980) have briefly examined the difference between the processes generating short-term and long-term inflation expectations, although the term structure of inflation expectations as such is not dealt with.…”