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EMPIRICAL
ECONOMICS
( Springer-Verlag 2001
Abstract. Tests of the Fisher e¨ect are plagued by high persistence in interest
rates. Instead of standard regression analysis and asymptotic results, methods
relying on local-to-unity asymptotics are employed in testing for the Fisher
e¨ect with monthly U.S. data covering the period 1953:1±1990:12. These
procedures are extensions of a recently presented method (Cavanagh, Elliott
and Stock (1995)) based on simultaneous con®dence intervals, and they have
the advantage of being asymptotically valid whether interest rates are integ-
rated of order one or zero, or near unit root processes. Taking appropriately
account of the near unit root problem the ®ndings in most of the previous
literature are recon®rmed. There is support for the Fisher e¨ect in the interest
rate targeting period (1953:1±1979:10) of the Federal Reserve but not in the
1979:11±1990:12 period.
1. Introduction
* I am indebted to Graham Elliott, Seppo Honkapohja, Johan Knif, Erkki Koskela, Pentti
Saikkonen, Matti VireÂn, Anders Warne and the three anonymous referees for useful comments.
The usual disclaimer applies. Financial support from the YrjoÈ Jahnsson Foundation and SaÈaÈstoÈ-
pankkien tutkimussaÈaÈtioÈ is gratefully acknowledged.
358 M. Lanne
small sample performance of the method. The empirical results are obtained
using extensions of the asymptotically valid method of Cavanagh, Elliott and
Stock (1995). The derivation of these extensions is deferred to the Appendix.
Section 4 concludes.
2. Econometric Methodology
Table 1. 95% con®dence intervals of the largest autoregressive roots of interest rates
1953:1±1990:12
i1 8 1.984 0.971, 1.007
i3 8 1.804 0.975, 1.008
1953:1±1979:10
i1 6 0.714 0.991, 1.015
i3 6 0.710 0.990, 1.015
1979:11±1982:10
i1 0 1.956 0.638, 1.094
i3 1 2.472 0.471, 1.065
1982:11±1990:12
i1 0 2.262 0.832, 1.029
i3 0 1.312 0.929, 1.044
The lag length k in the ADF tests was determined by step-down testing (Ng and Perron (1995)),
using a 5% level for each lag. The con®dence intervals were obtained by linear interpolation based
on the ®gures in Stock (1991, Table A.1).
360 M. Lanne
Elliott and Stock (1994) studied the properties of the t test statistic using
local-to-unity asymptotics, i.e. they parametrized the largest autoregressive
root of the regressor, r, as 1 c=T, where c is a constant and T is the sample
size. They reached two main conclusions. First, the asymptotic null distribu-
tion of the t statistic is nonstandard and depends on two nuisance parameters,
the local-to-unity parameter c and the long-run correlation between the error
terms of the regression model (1) and the autoregressive representation of the
regressor, i.e. on the simultaneity in the system. Of these the latter is con-
sistently estimable whereas the former is not. The overrejection in standard
inference is the worse the higher is the simultaneity. Second, the often applied
procedure of pretesting for a unit root in the spread and subsequently employ-
ing the consequent distribution theory also leads to overrejection. This is so
because asymptotically the rejection probability of the null hypothesis r 1 is
less than one, meaning that the pretest is not consistent in the local-to-unity
case. Hence the nonstandard critical values corresponding to the I
1 case are
too often selected and overrejection prevails.
Mishkin (1992) considered inference in the forecasting regression (1) as-
suming exactly I
1 in¯ation and interest rates and no cointegration. He ob-
tained the critical values of the t statistic under these assumptions, and found
no evidence for the Fisher e¨ect. The simulated distributions are, of course,
crucially dependent on the restrictive assumptions. If the largest autoregres-
sive roots of the series deviate from unity or are cointegrated contrary to these
assumptions, the estimated time series models used as DGPs are misspeci®ed.
In a related paper Mishkin (1995) considered di¨erent DGPs estimated with
the same data set. First, while still making the exact unit root assumption, he
assumed that the in¯ation and interest rates are cointegrated. Second, he esti-
mated the DGP without imposing the unit roots. In both cases the results
obtained using the consequent simulated critical values are similar to those
in his 1992 paper, with the exception of some evidence for positive
correlation between the real and nominal interest rates after 1979.2 The ®rst
DGP is, however, misspeci®ed, if the variables are not unit root processes,
and, as recently pointed out by Stock (1997), also the latter simulation proce-
dure (parametric bootstrap without imposing the exact unit root) is asymp-
totically invalid when the order of integration of the regressor is not known
(for a proof of this in the closely related case of the cointegration regression,
see Stock and Watson (1996)). Hence these procedures cannot be considered
satisfactory for testing the Fisher e¨ect in the framework of regression (1).
The list of asymptotically valid tests in models where the order of integr-
ation of the regressor is unknown, is still short (for a survey, see Stock (1997)),
and little is known about the relative merits of the di¨erent tests.3 A recently
presented contribution that looks promising, is due to Cavanagh, Elliott and
Stock (1995), who suggested basing inference on simultaneous con®dence in-
2 In Mishkin (1995) the regression model being studied instead of (1) has the ex post real rate as
the dependent variable.
3 It is worth noting that the lag augementation scheme of Toda and Yamamoto (1995) provides a
technically uncomplicated way of achieving asymptotically valid inference. The idea is to add to
the model one additional lag that is not restricted under the null hypothesis. However, as pointed
out by Stock (1997) the local asymptotic power of this procedure is lower than that of the alter-
native tests. Finite sample power is also likely to be low, especially in our model which involves
only one lag (see the simulation results of Dolado and LuÈtkepohl (1996)).
In¯ation and interest rates 361
3. Empirical results
In this section we apply the Sche¨e type procedure of Cavanagh et al. (1995)
to test the Fisher e¨ect. The data set consists of monthly observations of U.S.
one and three month Treasury bill rates and in¯ation rates computed from the
consumer price index from the period 1953:1±1990:12 (456 observations). The
same data were also studied by Mishkin (1992, 1995). Following Mishkin,
three subsample periods are considered in addition to the entire sample. There
is some empirical evidence suggesting that there were structural changes in the
relationship between in¯ation and interest rates when the Federal Reserve
System ceased targeting interest rates in 1979 and again when the targeting
was partially resumed in 1982 (see e.g. Huizinga and Mishkin (1986)). To be
able to compare our empirical results with those of Mishkin we have chosen
to take his subsample division as given. Whether such structural changes
really occurred and which the exact dates may have been, is of course, an in-
teresting question in its own right but it will not be studied here. The three
subsample periods are 1953:1±1979:10 (322 observations), 1979:11±1982:10
(36 observations) and 1982:11±1990:12 (98 observations).
To assess the severity of the near unit root problem let us ®rst take a look
at the estimates of the largest autoregressive roots of the interest rate process
and the simultaneity in the system. The 95% con®dence intervals of the largest
Table 2. Estimates of the long run correlation between the residuals of the ADF regression for the
m month interest rate and the in¯ation forecasting equation (1)
m 1 3
Sample period
The estimates are obtained by autoregressive approximation. AIC with a maximum of 10 lags was
used to select the lag length.
Table 3. 95% Sche¨e con®dence intervals of the slope coe½ents b m in the in¯ation forecasting
equation (1)
m 1 3
The con®dence intervals were solved on a grid with the values of c ranging from 40.0 to 9.5. The
lag length k was selected by AIC.
In¯ation and interest rates 363
7 Speci®cally, the in¯ation forecasting equation (1) and an autoregression for the interest rate
with a VAR model for the residuals were estimated for each of the sample periods. The error
^ distribution, where S^ is the estimated covariance matrix of the
terms were generated from N
0; S
®nal residuals.
364 M. Lanne
Table 4. Rejection rates of tests of the Sche¨e type test with nominal size U5%
m1 m3
The entries are based on 2,000 Monte Carlo replications of models for interest rates and in¯ation
(for details see footnote 7) estimated with data on the m-period in¯ation and interest rates from
the indicated sample period. T is the sample size.
4. Conclusion
In this paper we test the Fisher e¨ect according to which changes in short-
term interest rates primarily re¯ect changes in expected in¯ation. It has been
suggested that both in¯ation and nominal interest rates have unit roots, and
therefore the results obtained in much of the earlier empirical work relying
on standard inference are questionable. Since there is no theoretical reason
to assume these variables to be I
1, we apply the Sche¨e type approach of
Cavanagh et al. (1995) which is asymptotically valid under uncertainty about
the order of integration. The data set consists of U.S. short-term in¯ation and
interest rates covering the period from 1953 to 1990. The general conclusion is
that the Fisher e¨ect is absent in the post 1979 subsample periods but there is
support for it in the interest rate targeting period 1953:1±1979:10. A potential
explanation for the presence of the Fisher e¨ect in the former and absence in
the latter period is o¨ered by a change in the emphasis on in¯ation targeting
(see SoÈderlind (1999)).
There is some support for the one-for-one movement of in¯ation and
nominal interest rates in the entire sample and potentially in the interest rate
targeting period. In contrast, this hypothesis is clearly rejected in the post 1982
period. Also, the recent results of Evans and Lewis (1995) and Crowder and
Ho¨man (1996) lend support to the (full) Fisher e¨ect in the U.S. Using data
from 1947 to 1987 Evans and Lewis argue that taking account of changes
in the process of in¯ation it cannot be rejected that in the long run nominal
interest rates re¯ect expected in¯ation one-for-one. Crowder and Ho¨man, on
the other hand, reconcile data from 1952 to 1991 with the Fisher hypothesis
by explicitly adjusting the interest rate for time varying taxes. Neither paper
has subsample results.
Econometric appendix
xt rxt 1 v1t
where r 1 c=T, vt
v1t ; v2t 0 F
L 1 et , F
L is a kth order lag poly-
nomial matrix having all roots outside the unit circle, with typical element
Fij
L (Fij 0 I2 ) and et
e1t ; e2t 0 is a martingale di¨erence sequence with
constant conditional covariance matrix S, and supt Eeit4 < y, i 1; 2 and
2
Ex10 < y. Hence serial correlation in the error terms is assumed to be well
described by an autoregressive process. As far as the empirical application
of the paper is concerned, the latter equation corresponds to the in¯ation
forecasting equation (1), and the ®rst equation can be seen as the generating
mechanism of the interest rate.
Model (2) can be written in the following error-correction form, where the
error-correction term ut g0 xt yt is known under the null hypothesis
g; c
g0 ; c0 :
X
k X
k 1
Dxt c10 c11 xt 1 c12 ut 1 a1i Dxt i b1i Dyt i e1t
i1 i1
X
k X
k 1
Dyt c20 c21 xt 1 c22 ut 1 a2i Dxt i b2i Dyt i e2t :
3
i1 i1
The null hypothesis implies two restrictions on the coe½cients of model (3):
Tc11 c0 F11
1 and Tc21 c0 F21
1. The coe½cients of the lag polyno-
mials are, of course, unknown, but in the test statistics F11
1 and F21
1 can
be replaced by their consistent estimators under the null hypothesis, F ^
1
Pk Pk 1 ^ ^ Pk P11k 1 ^
1 a^ g b g c and ^
F
1 g ^
a g
i1 1i 0 i1 1i 0 12 21 0 i1 2i 0 i1 b2i
^
g0 c22 . We obtain the statistic
!
1 0 ^ 1 2X T
m2
W 1 rT S T xt 1 rT ;
4
2 t2
P
where rT
T c^11 c0 F ^11
1; T c^21 c0 F
^21
1 0 , S^ 1=
T k T ^t e^t0 ,
tk1 e
0 m
and e^t
^ e1t ; e^2t are the OLS residuals from (3), xt 1 xt 1 1=
PT
T 1 t2 xt 1 . It is easy to see that under the null hypothesis
g; c
g0 ; c0 , W1 converges to the same limiting distribution as Cavanagh et al.
obtained in the simpler case with no error autocorrelation since the only dif-
ference between the models is in the dynamics and only the coe½cients of the
lagged level are involved in the test.
If xt 3 is the regressor in (2) instead of xt 1 the error-correction form of
the model corresponding to (3) has lags of Dxt up to k 2 while the longest
lag of Dyt is still k 1. In this case the joint null hypothesis g g0 and c
c0 implies additional restrictions on the coe½cients of the subsequent error-
correction model. The test statistic, W3 , can be written as the sum of W1 and
366 M. Lanne
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