Error Correction and Term Structure of U.S. Treasury Bills and Bonds under Different Monetary Regimes

This paper develops a short-term interest rate model that integrates the error correction theorem into the term structure theory through the dynamic adjustment processes in expected inflation rate. The theory contends that the changes in short- term interest rates can be predicted by their own stochastic processes, the changes in long rates, and the error correction term, the latter corresponds to the slope of the yield curve. The evidence, derived form the entire spectrum of the yields from the US Treasury bills and bonds, concludes that the error correcting term has predictive power for projecting future interest rate movements. Consistent with the partial adjustment hypothesis, the absolute value of the slope coefficient is less than unity, rejecting the pure expectations hypothesis. However, the magnitude of this coefficient is much larger estimations are made by employing the monthly data as compared with that of the weekly data. The evidence also indicates that the longer-term interest rate has a positve effect on explaining the short-rate movements. Our study indicates that the error correction model works better for the short-end maturity and under a monetary aggregate regime.