Categorical Thinking about Interest Rates

77 Pages Posted: 23 Apr 2024

See all articles by Kelly Shue

Kelly Shue

Yale School of Management; National Bureau of Economic Research (NBER)

Richard Townsend

University of California, San Diego (UCSD) - Rady School of Management

Chen Wang

University of Notre Dame - Mendoza College of Business

Date Written: April 21, 2024

Abstract

Rational expectations imply that the current long-term interest rate should already incorporate public knowledge of anticipated increases in short rates. Yet, there is a widespread misconception that expected future shifts in the short rate forecast corresponding future movements in the long rate. We hypothesize that people lump short- and long-term interest rates into the coarse category of ``interest rates,'' leading to overestimation of their comovement. We show that categorical thinking about interest rates is evident even among professional forecasters and distorts the real behavior of borrowers and investors. Expectations of rising short rates prompt households and firms to rush to lock in long-term debt before further increases in long rates, reducing the effectiveness of monetary policy. Investors are also less willing to hold long-term bonds because they anticipate future increases in long rates. The increase in supply and decrease in demand for long-term debt cause long rates to overreact to changes in short rates, and can help explain the excess volatility puzzle in long rates.

Keywords: categorical thinking, interest rates, expectations, subjective beliefs

JEL Classification: E43, G12, G41

Suggested Citation

Shue, Kelly and Townsend, Richard and Wang, Chen, Categorical Thinking about Interest Rates (April 21, 2024). Available at SSRN: https://ssrn.com/abstract=4802300 or http://dx.doi.org/10.2139/ssrn.4802300

Kelly Shue

Yale School of Management ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Richard Townsend

University of California, San Diego (UCSD) - Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States

Chen Wang (Contact Author)

University of Notre Dame - Mendoza College of Business ( email )

Notre Dame, IN 46556-5646
United States

HOME PAGE: http://chenwang.one/

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