The determination of long-term interest rates and exchange reates and the role of expectations

During the conference on "Financial structure and the monetary policy transmission mechanism", held at the BIS in November 1994 (see CB 394), a general interest was expressed in having a regular annual meeting for central bank econometricians and model builders. The periods of turbulence during the past years, first in the world bond markets and later in foreign exchange markets, have generated further interest in the question of what drives movements in long-term interest rates and exchange rates. In particular, attention has focused on whether such changes are caused by revised expectations of the so-called fundamentals or are the result of overshooting due to "fads" or other herd-like behaviour. Since both the exchange rate and the long-term interest rate are important links in the transmission process of monetary policy, analyses and discussions of how to model the influence of unobservable expectations seem especially important in this context. In some countries, increasing government and foreign debt ratios may also have affected the risk premia on long-term interest rates and exchange rates as well as the interaction between interest rates and exchange rates.

Against this background the BIS invited central bank econometricians and model builders to a conference held at the BIS on 14th and 15th December 1995 on the following topic: "The determination of long-term interest rates and exchange rates and the role of expectations".

The presentation and discussion of the fifteen contributions (including comments by discussants) took place in three separate sessions; a final and relatively brief session was mainly devoted to the need for and interest in regular meetings of this kind and to potential topics for future meetings. The contributions are reproduced on the following pages in the order in which they were presented, while the remainder of this introduction provides a summary of each paper. It concludes with a brief "cross-paper" discussion of the main themes of the meeting, including (i) the modelling of expectations and the results obtained; and (ii) the extent to which estimates of the two key equations (long-term interest rates and exchange rates) made use of and validate three principal theories in this area: purchasing power parity, uncovered interest parity and the expectation hypothesis of the yield curve.