Abstract:

The Fisher Effect has proven to be an essential aspect of both domestic and international economics, and a crucial component of the rational expectations theory. Given its importance, I will be testing whether Michigan Survey data on consumer inflation expectations matches increases in Treasury yields point-for-point; said differently, I will be testing the hypothesis that the Fisher Effect holds true for Michigan Survey respondents. Whereas prior literature either utilizes ex post inflation data, or ex ante professional forecasts to prove this hypothesis, I will be utilizing consumer forecasts, which are generally thought to accurately reflect public, non-professional opinion. Accordingly, I will conduct a basic time series analysis by utilizing an ADL(x,y) model to regress Treasury yields upon lagged values of Treasury yields and inflation expectations. Ultimately, I will strive to show that consumer inflation expectations (as measured by Michigan Survey) is a good predictor of future Treasury yields. After Irving Fishers famous hypothesis on the real rate of interest, there has been much debate within the economics realm as to whether nominal interest rates follow inflationary expectations perfectly. Fisher, accordingly, contended that each percentage point increase in the rate of expected inflation would be followed by a percentage point increase for nominal bond yields. This assertion ultimately defends the theory of rational expectations; if proven to hold some truth, markets can be assumed to generally follow some degree of rationality. This assumes, of course, that market participants involved are completely informed within this decision-making process. Participants who are either unable or incapable of forecasting inflation correctly are obviously unable to forecast proper nominal yields. Multiple reports1 that study the Fisher Effect have concluded that there are significant results when regressing nominal interest rates upon inflationary expectations. Economists such as William Gibson (1972) have provided evidence that the Fisher Effect has had an increasing impact over time; many have concluded, albeit with different methods, that a one-for-one relationship 1 Meyer and Sahu(1995), Wallace and Warner(1993), Gibson(1972), Cargill and Meyer(1978), and Evans and Lewis(1995) all find statistically significant results

between inflation expectations and nominal interest rates are statistically significant. For example, Cargill and Meyer (1978) reinforce Gibsons findings, yet state that the significance is ultimately dependent upon the time studied. Ultimately, the Fisher Effect should also hold true for consumers expectations. I therefore hypothesize that the Michigan Survey on Consumer Inflationary Expectations accurately forecasts future rates of interest. Prior economists (Cargill & Meyer, 1978) characterize the nominal interest rate as a function of the real (equilibrium) rate of interest, expected inflation rate, the risk of default, and a liquidity premium. Said differently:

Rt = rt + t + dt + lt
This equation is essentially the Fisher equation with added default risk and liquidity premiums. Hence, by utilizing data of Treasury Bond yields, one can eliminate both the default risk and liquidity premium incorporated into nominal yields, as United States Treasury Bonds are thought to be risk-free, highly liquid assets. The equation, therefore, essentially becomes:

Rt = rt + t
This equation is essentially the Fisher Equation. Treasury Yields could therefore track the soundness of the Fisher Equation much more easily, as liquidity and default variables can be held constant at 0. William Gibson, in Interest Rates and Inflationary Expectations (1972), tests this equation with a simple regression by utilizing data on various treasury yields and inflationary expectations. Gibson uses data from the Livingston Survey in specific to gauge inflationary expectations; contrary to other papers, Gibson utilizes ex ante data (as per the theory of rational expectations) to test his hypothesis that nominal yields follow inflationary expectations perfectly. As per the regression equation i = b0 + b1p*, interest rates should perfectly follow expectations point for point if the slope coefficient is one.

Ultimately, Gibson found that inflationary expectations have a very strong influence on interest rates, even over a period less than a year. The results of the paper, however, yield two differing outcomes. During the earlier period (1952-1959), inflationary expectations (as per the Livingston Survey) were shown to have little impact on treasury yields; 1 ranged from .09-.45, whereas R2 ranged from .07-.26. Gibson finds 1 to be close to 1 and R2 to be significantly high during his later observations (1959- 1970); this would imply that increases in the rate of expected inflation yield nearly identical increases in the nominal interest rate. After further testing his data for breaks, Gibson posits that the rate of accuracy largely has to do with the severity of inflation. If inflation were to be lower than information and/or transaction costs, an investor would be rational in forgoing a forecast; this would translate into an unpredictive model (as was seen during the earlier period). Because the rate of inflation was substantially higher after 1959, investors and consumers had higher incentives to predict (accurately) future rates of inflation. Accordingly, as Mankiw (2003) states, the gap between professional and non-professional expectations decreased as non-professional forecasts became more accurate. In addition, Gibson posits that the cost of information (i.e. the costs incurred to forecast inflation) could have decreased significantly during sometime in the later period. The paper later finds expectations to be more accurate (i.e. at forecasting the true value of inflation) during the later period than the earlier period2. Gibson eventually concludes that inflationary expectations yield significant impact on bonds with a maturity of one-year or less, and that the real rate of interest is not affected by price expectations over a six-month period and that interest rates fully adjust to expectations within six months. The model within the paper contains certain theoretical assumptions. First, survey respondents (in the Michigan Survey) accurately represent the aggregate expected inflation rate for the United States. In order for the outcome of the time series 2 On page 862, Gibson even finds inflation expectations to be more accurate during the later period.

regression to be significant, the inflationary expectations of survey respondents must accurately predict market interest rates. These respondents must also base their forecasts based upon the rational expectations theory as well. In specific, inflationary forecasts should contain both a fundamental (equilibrium rate) as well as an error term which accounts for unexpected shocks. Since the expected inflation rate contains a unit root, it is highly unlikely that prior rates of inflation can predict future rates (as the adaptive expectations hypothesis posits). Given the large forecasting errors which may be present in ex post inflation data, ex ante inflation data will used in order to avoid falsely rejecting a unit root (Sun & Phillips, YEAR). According to Sun and Phillips, this false rejection, along with evidence that nominal rates contain unit roots, may lead to the false conclusion that the real rate of interest is I(1). Accordingly, the data utilized within my study will be the Michigan Survey of Consumer Inflationary Expectations (1978-2001), along with Year and Six-Month Annualized Treasury Yields (1978-2001). Given the nature of the data (i.e. time series data), I will utilize an ADL(x,y) model to test the hypothesis that prior rates of inflation (and interest rates) influence future rates of nominal Treasury yields. The initial model will look as follows: it = 0 + 1it-1++xit-x+ 1t-1++yt-y This model, however, must account for various preconditions required for time series regressions. The first precondition that the data must uphold, stationarity, exhibits problems in two ways. First, the data appears to exhibit long trends at certain points. Using an Augmented Dickey-Fuller test, I found all of the data to support the null hypothesis of a unit root. Prior findings have also failed to reject the null hypothesis of a unit root on nominal Treasury yields and inflationary expectations as well3. In specific, each tested dataset was unable to reject the null hypothesis of a unit root at the 1%, 5%, and 10% significant level, with each p-value being well over .1. 3Lewis(1995), Stock and Watson(1988), Atkins(1989), MacDonald and Murphy(1989), and Campbell and Shiller(1987) have all found this data to follow stochastic trends.

 Augmented Dickey-Fuller Test for Initial Data Data Michigan Survey Treasury (Year) Treasury (Six Month) The original model, therefore, needs to be reformulated by taking the first differences of each variable and lag-value. After doing so, and retesting each dataset, I found each ADF statistic to have significantly higher absolute values. Accordingly, each p-value indicates that all statistics were significant at the 5% level. Furthermore, only the Six- Month Treasury dataset failed to be found statistically significant at the 1% level. This would indicate that taking the first difference of each dataset makes the data stationary; this could thereby confirm the economic theory behind these tests: namely, that inflationary expectations and interest rates follow a random walk. Augmented Dickey-Fuller Test for First Differenced Data Data (First Diff.) Michigan Survey Treasury (Year) Treasury (Six Month) Since inflation expectations and interest rates are (at least) somewhat dependent upon future random shocks to the economy, both should follow stochastic trends (i.e. random walks). The new model should therefore look as follows: ADF Statistic P-Value Unit Root -6.7656 -7.2623 -3.8393 >.01 >.01 .01957 No No No ADF Statistic -1.5473 -2.7768 -2.3656 P-Value .7669 .2488 .4246 Order of Integration I(1) I(1) I(1)

ADL(x,y): it = 0 + 1it-1++xit-x+ 1t-1++yt-y

Structural breaks within the data also pose a problem for the stationarity precondition. Major shocks to inflation (i.e. the 1973 Oil Embargo), for example, could manipulate the data and provide imprecise regression results by incorporating an OLS regression estimate based off of two different time periods and two different true regression coefficients. After testing for breaks, two specific dates (November 1981, March 1993) were found to produce structural breaks in the data of inflationary expectations, and three specific dates (July 1982, January 1986, March 1991) were found to produce structural breaks in the data of interest yields. Prior reports have found similar findings for inflationary expectations by utilizing a CUSUM test to test for structural breaks in inflation (Evans & Lewis, 1995); Accordingly, in order to avoid these known changes in the population, I will analyze the data spanning from April 1991 to August 2001. Given these adjustments, the data should now uphold all four regression preconditions. More specifically, the models soon to be tested will be found to have residuals with a conditional mean of zero. Also, the data tested does not exhibit breaks or trends, so the data can be said to be stationary. Given the fact that average inflationary expectations and nominal interest rates rarely fluctuate over 5%, the data appears to have nonzero, finite fourth moments. Finally, no variables within the tested models will appear to be perfectly multicollinear with another. After testing for the correct lag-length to be used in the end model, I found an ADL(7,7) model to provide the lowest AIC values for each regression (i.e. six month and year treasuries as the dependent variable). The best model is accordingly: it = 0 + 1it-1++7it-7+ 1t-1++7t-7

 Lowest AIC Values for Treasury-Year Model # ADL(3,12) ADL(4,12) ADL(5,7) ADL(5,12) ADL(7,6) ADL(7,12) ADL(6,12) ADL(9,12) ADL(6,7) ADL(7,7) Using the Breusch-Pagan test to test for conditional heteroscedasticity, both ADL(7,7) models failed to reject the null hypothesis of homoscedasticity at the 10%, 5%, and 1% level4. The data therefore fails to confirm the alternative hypothesis of conditional heteroscedasticity at the 10%, 5%, and 1% level. Model Statistics (Treasury-Year) Variable Intercept DTY1 DTY2 Estimate -0.00336 .41851 -.10623 Std. Error .019732 .100769 .110706 P-Value .8651 .0001 .3396 Model Statistics (Treasury-Six Months) Variable Intercept DTH1 DTH2 Estimate -.000253 .2952656 .0574072 Std. Error .018375 .099735 .104134 P-Value .9891 .0038 .5827 AIC Value 19.12 18.91 17.89 17.14 17.04 16.96 16.83 16.38 16.16 15.33 Lowest AIC Values for Treasury-Six Month Model # ADL(5,12) ADL(7,6) ADL(7,7) ADL(8,12) ADL(6,7) ADL(5,7) ADL(1,7) ADL(2,7) ADL(9,12) ADL(4,12) AIC Value 33.83 33.63 31.77 32.66 33.06 33.89 34.95 34.25 33.44 35.23

4 The p-values for Treasury-Year and Treasury-Six Month are .2672 and .207

DTY3 DTY4 DTY5 DTY6 DTY7 DIE1 DIE2 DIE3 DIE4 DIE5 DIE6 DIE7

.23207 -.16989 .02164 .01148 .10058 .07591 .07139 .07560 .05212 .03562 -.00745 .06373

.112786 .114351 .114622 .114405 .106406 .125515 .1427 .144357 .146068 .140943 .132951 .116119

.0422 .1405 .8506 .9202 .3468 .5467 .618 .6016 .722 .801 .9554 .5843

DTH3 DTH4 DTH5 DTH6 DTH7 DIE1 DIE2 DIE3 DIE4 DIE5 DIE6 DIE7

.2202607 -.123518 -.010591 .0787512 .0823162 -.027646 -.026043 -.045958 -.047928 -.103242 .0010714 -.037397

.106298 .107707 .107702 .107151 .104997 .115636 .131724 .131535 .134877 .126987 .121345 .108404

.0408 .2542 .9219 .4641 .4349 .8115 .8437 .7275 .7231 .4181 .9929 .7308

In addition, the datasets may be cointegrated, so it is necessary to test the residuals for stationarity. Both models rejected the null hypothesis of a unit root at the 1% level, which would lead to the conclusion that the datasets are in fact cointegrated. Using the Engle-Granger method, I first estimated the relationship between Treasury yields and inflation expectations by regressing the first upon the latter. I then incorporated this relationship into the original regression. The addition of a cointegration term, however, had minimal effects on the Treasury-Six Months model. The cointegration term, though, had a significant impact on the Year-Treasury model; the results of the model are given below. Final Model Statistics (Treasury-Year) Variable Intercept DTY1 Estimate -.03025 .51566 Std. Error .06007 .10062 P-Value .615669 .000001 Variable DIE1 DIE2 Estimate .22517 Std. Error .38085 P-Value .885354 .555702 -.04896 .33872

DTY2 DTY3 DTY4 DTY5 DTY6 DTY7

-.37034 .02136 -.24585 .31907 -.36196 -.00395

.10686 .10807 .10434 .10818 .10681 .10008

.000781 .843705 .020408 .003966 .001005 .968591

DIE3 DIE4 DIE5 DIE6 DIE7 Z

-.11257

.38498

.770587 .386905 .629083 .531706 .348676 .173719

-.34506 .39705 -.18449 .38078 -.23104 .36814 -.31386 .33334 -0.09051 0.06606

In conclusion, both models residual mean is zero. The adjusted R-squared of the final ADL(7,7) model for Six-Month Treasuries is .08704; this model is not statistically significant at the 5% level, as its p-value is .05128. The ADL(7,7) model for Year- Treasuries was found to be statistically significant at the 5% level, with a p-value of .01928; its adjusted R-squared improved to a value of .1157. After adjusting for cointegration, however, the final Year-Treasury model was found to be statistically significant at the 1% level, with a p-value of .00002; the model had an adjusted R- squared value of .2714, which was a significant jump from the previous model. In addition, the skewness of each dataset was relatively mild. The absolute value of the skew (i.e. residual, Year-Treasury, Six-Month Treasury, and Inflation Expectations skew) never exceeded .9, and rarely exceeded .5. After observing the fit of the model, however, the independent variables seem to poorly describe the movements MODEL FITS
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 in the dependent variable, the first difference of treasury yields. Two possible explanations could be offered as to why this is so. The most obvious reason is the possibility of a flawed method; mistakes throughout the process of estimating the ADL model could have produced flawed results, just as certain preconditions (for this model to be statistically significant) may not have been met. Another possible explanation is the nature of the data itself. First, the initial assumption of rational forecasts may not withhold certain rigorous tests. Michigan Survey respondents may not share the degree of rationality required for the fisher equation. Albeit this evidence being inconclusive, there is certainly evidence that consumer inflation forecasts are not fully rational. Economist Gregory Mankiw (2003) specifically reports that, for consumers the interquartile range of expected inflation goes from 0% to 5%, whereas economists interquartile range of forecasts is 1.5% to 2.5%. In addition, the distribution of consumer forecasts tend to have long tails over the long run, with over ten percent of respondents expect inflation to reach 10% often times. Mankiw also finds consumer forecast errors to be highly persistent, and unreflective of current macroeconomic data. Since consumer forecasts tend to be consistently skewed positively, less accurate, and have a higher rate of variance than professional forecasts (i.e. Livingston Survey), regressing interest rates on the mean forecast rate can prove to be inaccurate. Second, low and relatively constant expectations might have reduced the reliability of forecasts; this hypothesis could confirm William Gibsons prior speculation. Constantly low inflation rates may translate into low opportunity costs for ignoring these forecasts. As consumers have less incentive to update their expectations, their forecasts may become more inaccurate; over the time period analyzed, inflation failed to break 3.5%, and had a mean rate of 2.887%. It should be noted that interquartile

forecasts failed to reduce significantly in response to the increasingly stable rate of inflation. Ultimately, the data in Michigan Survey should prove to be ineffective in terms of constructing market forecasts. Respondents are generally irrational, and definitely do not hold the degree of rationality required in various economic models; their opinions/forecasts clearly hold little weight (as measured by adjusted R-squared) in bond markets. Economic policy, therefore, should strive to answer why consumer forecasts consistently fail to predict inflation expectations. One approach could be to analyze the expectation formation process for consumers5. Generally speaking, however, more research needs to ask why these forecasts are generally biased and/or inaccurate; the answers to such a question, which could lie within the formation process of expectations, could help explain why consumer forecasts of inflation fail to uphold the Fisher Effect. 5 Christopher Carrol (2003) posits that consumer forecasts are derived from news reports. Accordingly, the amount of news reports is positively correlated with the accuracy for consumer inflation forecasts.

Annotated Bibliography
Cargill, T. F., & Meyer, R. A. (1980). The Term Structure of Inflationary Expectations and Market Efficiency. The Journal of Finance, 35(1), 57-70. Cargill and Meyer construct a model which expands upon the Fisher Equation; they incorporate default risk and liquidity premium into this model, and manipulate it to account for variations in the model (i.e. to account for returns after taxes, or the term structure of interest rates). Interestingly, they confirm Gibsons findings that a complete adjustment to expectations were made in the 1960s. Evans, M. D., & Lewis, K. K. (1995). Do Expected Shifts in Inflation Affect Estimates of the Long-Run Fisher Relation. The Journal of Finance, 50(1), 225-251. Evans and Lewis use modern time-series techniques to test whether inflation expectations account for changes in interest rates; they originally show that the real rate of interest tends to exhibit permanent shocks. When incorporating a Markov model which accounts for anticipated shift in the real rate of interest, however, they are unable to disprove the Fisher Effect. Gibson, W. E. (1972). Interest Rates and Inflationary Expectations: New Evidence. The American Economic Review, 62(5), 854-863. William Gibson argued that market yields for government bonds do not always follow professional inflationary expectations. Albeit successfully doing so later in the 20th century, Gibson posits that this is largely due to lower information costs and/or higher opportunity costs (inflation). His work, however, is not necessarily reliable, as it does not contain modern measures that control for cointegration and conditional hetroscedasticity; his main insight is the reason for which interest

rates may or may not follow inflation expectations (i.e. information and opportunity costs). Mankiw, Gregory N., Reis, Ricardo, and Justin Wolfers. Disagreement About Inflation Expectations. NBER Macroeconomics Annual 18 (2003): 209-248. Print. Mankiws work largely focuses upon different theories for inflationary expectations. After discussing the strengths of traditional adaptive and rational expectations models, Mankiw then tests a new model in which agents are rational, but do not update their expectations continuously. He finds evidence that such a model is more optimal than the prior two. This work is primarily used for facts about consumer expectations (as measured by the Michigan Survey. Sun, Y., & Phillips, P. C. (2004). Understanding the Fisher Equation. Journal of Applied Econometrics, 19(1), 869-886. This paper is primarily used to exhibit why ex post data can produce deceptive results for time-series analyses. Sun and Phillips, in contrast to other economists, use ex ante data to disprove the Fisher Effect by showing the real rate of interest to be integrated of order one. Wallace, M. S., & Warner, J. T. (1993). The Fisher Effect and Term Structure of Interest Rates: Tests of Cointegration. The Review of Economics and Statistics, 75, 320-324. The paper ultimately shows evidence for cointegration between expected inflation and long/short term interest rates. Wallace and Warner prove this primarily by testing the change in CPI, T-bills, and T-bonds for unit roots; they then utilize the Johansen Test to test for cointegration.