7.8 The signicance of term structure theories

7.7.5Preferred habitat

It is easy to think of groups of savers that may be strongly attached to particular parts

of the market for funds – for instance, small savers who habitually save in National

Savings or building society accounts despite changes in interest rate differentials,

or those nancial institutions which have a denite preference for one part of the

market. Nonetheless, the notion that there is no substitutability among assets of

different maturities appears extreme.

A compromise position is to accept that people do have attachments to parts of the

market (their preferred habitats), which are sufciently strong that they are unlikely

to be broken by small changes in interest rates. However, larger changes in interest

rates may persuade people to move some (but not all) of their assets of particular

maturities to others. That is, assets of different maturities are substitutes for each

other, but are imperfect substitutes. In our numerical example, the fall in current

one-year interest rates from 8 to 7.5 per cent may have little or no effect on ve-year

rates; but if one-year rates fell to say 7 per cent, we might expect some switching

towards long-term assets and some fall in the ve-year rate, although we would also

expect the gap between one-year and ve-year rates to grow.

7.7.6A summary of views on maturity substitutability

We thus have a range of views from one extreme to the other. At one extreme we can

apply the notion of rational expectations to the expectations theory. This suggests that

market agents make efcient use of all available information in order to maximise

utility and implies that any small change in interest rate in one part of the market for

funds will be instantaneously transmitted to all other parts of the market. All interest

rates will move together and differentials between interest rates on assets of different

maturities will depend entirely on expectations of future changes in interest rates.

At the other extreme we have the notion of complete market segmentation with its

assumption of no transmission between interest rates on assets of different maturities.

In between, we have the idea of preferred habitats, with imperfect substitution.

7.8The signicance of term structure theories

The view held about the nature of the term structure of interest rates is important at

both a theoretical and a practical policy level. The theoretical issue is the usefulness of

monetary policy. The difference of opinion depends on two additional assumptions.

Firstly, Keynesian economists have generally held that monetary policy operates

through the effect of interest rates on the level of investment and hence on the level

of aggregate demand. Thus, a government wishing to reduce inationary pressures

in the economy will need to raise interest rates in order to reduce investment (and

expenditure on consumer durables).

Secondly, it is usually accepted that interest rates on assets of different maturities

are important to different groups of economic agents. In particular, much bank

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Chapter 7 • Interest rates

borrowing is for short periods and so it (and hence bank lending, bank deposits and

the rate of growth of the money supply) will depend on what happens to short-term

interest rates. Again, the international ow of short-term funds (‘hot money’) will

depend on what happens to short-term interest rates in different countries. However,

the raising of funds for long-term investment projects is held to be related more to

long-term rates of interest.

If we accept a strong version of the expectations hypothesis, we shall believe that the

monetary authorities need only bring about a small change in interest rates at the short

end of the market and this will quickly feed through to other interest rates and have

the desired effect on investment. But if we accept something more like the segmented

market approach, we shall argue that long-term rates may be affected by government

monetary policy only to a very limited extent, and perhaps only very slowly.

Consequently, supporters of the notion of market segmentation are sceptical of

the ability of monetary policy to inuence the level of aggregate demand and tend

instead to be supporters of scal policy. Monetarists believe that monetary policy

does not only operate through interest rate changes. Nonetheless, they do see the

interest rate channel as a powerful one because they argue that small changes in

interest rates are rapidly communicated from one part of the market to another.

At a practical level, the notion of market segmentation opens up the possibility that

monetary authorities might try deliberately to alter the term structure of interest rates

so as to achieve two separate targets although this has not been attempted for many

years. The aim was usually to raise short-term rates of interest without causing long-

term rates to rise. It was hoped that, by so doing, short-term ows of hot money would

enter the economy, temporarily improving the balance of payments and taking down-

ward pressure off the country’s exchange rate without causing domestic investment

to fall. In other words, the monetary authorities tried to overcome what they saw

as temporary balance of payments problems without adjusting their exchange rates

and without causing a recession in the domestic economy. Opponents of market

segmentation have never believed that such attempts to ‘twist’ the interest rate struc-

ture were sustainable in anything but the shortest of short runs. Market forces, they

argued, were much too powerful to allow governments to control the term structure of

interest rates. This debate lost a lot of its force when economies moved away from xed

exchange rates and the need to overcome balance of payments decits by attracting

ows of hot money from abroad largely disappeared. It is now widely accepted that

changes in short-term rates will feed through into longer-term rates quite rapidly.

The term structure is also used in two distinct areas of forecasting. In international

nance, the term structures of interest rates on different currencies imply, in the

absence of restrictions on international capital mobility, expected exchange rate

changes. The theory underlying this use is explained in Chapter 8.

More recently, great interest has been shown in the use of the term structure as

an indicator of the stance of monetary policy. The argument for the use of the term

structure in this way rests upon a combination of the pure expectations hypothesis

with its assumption of risk-neutrality and the Fisher effect, set out in section 7.1.

If the present pattern of interest rates is determined by expected future rates, then

today’s term structure should be an accurate predictor of future nominal interest

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