Rational expectations imply that the current long-term interest rate should already incorporate public knowledge of anticipated increases in short rates. Yet, there is a widespread misconception that expected future shifts in the short rate forecast corresponding future movements in the long rate. We hypothesize that people lump short- and long-term interest rates into the coarse category of ``interest rates,’’ leading to overestimation of their comovement. We show that categorical thinking about interest rates is evident even among professional forecasters and distorts the real behavior of borrowers and investors. Expectations of rising short rates prompt homebuyers and firms to rush to lock in long-term debt before further increases in long rates, reducing the effectiveness of monetary policy. Investors are also less willing to hold long-term bonds because they anticipate future increases in long rates. The increase in supply and decrease in demand for long-term debt cause long rates to overreact to changes in short rates, and can help explain the excess volatility puzzle in long rates.
Notre Dame, Yale SOM, Rutgers, Indiana Kelley, Harvard Business School