We identify a common misconception that expected future changes in short-term interest rates predict corresponding future changes in long-term interest rates. People forecast similar shapes for the paths of short and long rates over the next four quarters. This is a mistake because long rates should already incorporate public information about future short rates and do not positively comove with expected changes in short rates. We hypothesize that people group short- and long-term interest rates into the coarse category of “interest rates,” leading to overestimation of their comovement. We show that this categorical thinking persists even among professional forecasters and distorts the real behavior of borrowers and investors. Expectations of rising short rates drive households and firms to rush to lock in long-term debt before further increases in long rates, reducing the effectiveness of forward guidance in monetary policy. Investors sell long-term bonds because they anticipate future increases in long rates. The result- ing increase in supply and decrease in demand for long-term debt cause long rates to overreact to expected changes in short rates, and can help explain the excess volatility puzzle in long rates.
Notre Dame, Yale SOM, Rutgers, Indiana Kelley, HBS/MIT, Duke Fuqua, Georgetown McDonough, Cornell, OSU; SITE (Frontiers of Macroeconomic Research; Psychology and Economics), UGA Fall Finance Conference, Chicago Booth Behavioral Approaches to Financial Decision Making Conference, NBER Behavioral Finance Meeting (Fall 2024), 14th ifo Conference on Macroeconomics and Survey Data