Conventional Valuation and the Term Structure of Interest Rates

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There does not appear to be a general tendency for long-term interest rates either to overreact or to underreact to short-term interest rates relative to a rational expectations model of the term structure. Rather, there appears to be some tendency for markets to set long-term interest rates in terms of a convention or rule of thumb that makes long rates behave as a distributed lag, with gradually declining coefficients, of short-term interest rates. People seem to remember the recent past but blur the mare distant. In some monetary policy regimes this convention implies overreaction, in others underreaction.

Published: Rudiger Dornbusch et. al. eds., Macroeconomics and Finance: Essays in Honor of Franco Modigliani, Cambridge, MIT Press, 1987

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