Not Warranted

The Attack on Rational Expectations

By Steven J. Grisafi, PhD.

Among the most castigated notions of contemporary macroeconomics is the Hypothesis of Rational Expectations. This hypothesis suffers excoriation from multiple viewpoints of economists, especially from heterodox and behavioral economists, and receives support only from those economists well versed in mathematical methods. My inquiry into empirical data of price movements of financial securities has led me to believe that those who excoriate the Rational Expectations Hypothesis are whipping the wrong culprit.

The problem, as I see it, is that equilibrium is a condition rarely achieved in financial markets. Since financial markets are more prone to be driven by the profit motive than other markets, such as the labor market, one can expect that equilibrium is rarely a condition to be found within any economic system. Recognizing this one ought to understand that there is no point to criticize the assumptions upon which the system equations are based if the system equations never yield the solution one uses to measure their performance. More often than not, the financial markets remain in a state of transient behavior and their equilibrium condition is almost never achieved. Hence, one ought recognize that the solutions to the system equations of economic models are estimates of an expected equilibrium condition that one never actually has a chance to measure.

One of the better ways in which to view this failure of mathematical modeling of economic systems is through an inquiry into price and interest rate movements within a bond market. It is a common understanding that bond prices move inversely with respect to interest rate movements. But how exactly is this relationship described mathematically. It is not a simple inverse proportionality. When I began my development of Finance Rheology business news media did report both the current dirty bond price and the interest rate for the more prominent government bonds, but no longer do they do so. Now market observers are left to assume the operation of an inverse relationship of bond price and interest rate movements but no mathematical description for this inverse relationship exists. While perusing the doctoral dissertation of Nobel Laureate Professor Robert Schiller I found within it market equations which could, in principle, be used to compute an estimate of dirty bond price movements when knowing each and every extant original bond coupon. However, such a spectacular feat implies the assumption of a closed system. That is to say that when one sells a particular bond, abandoning its income stream, the proceeds are then invested into the income stream of another bond within that same bond market. The assumption of a closed system is clearly implausible because we know that the proceeds of the sale of a bond may find itself being stuffed under a mattress somewhere if it doesn’t find its way into some other financial securities market. Hence, in reality, we cannot actually discern the exact mathematical description for the inverse bond price and interest rate movements for any debenture market. Investors are correct to have the rational expectation that bond prices will presumably fall upon increases in interest rates but any failure of this rational expectation to materialize is solely a result of the failure of financial markets to remain as closed systems.

Here in the United States we have recently experienced a failure of the rational expectation of bond price and interest rate movements. Treasury bond prices have fallen dramatically over the past year as the Federal Reserve Bank has repeatedly hinted, through its periodic announcements, that the Bank will soon raise their Federal Funds Rate. Responding to such hints, investors have been selling Treasury bonds from their portfolios anticipating these interest rate hikes. But because the Federal Reserve Bank balked on several occasions to raise interest rates, the yields on Treasury securities have not risen commensurate to their price falls. One may try to argue that this merely implies a modification to a linear proportionality constant, but the reality is much more complicated than that. Bond prices fell destroying the wealth they once represented and no commensurate increase to the income stream they provide has materialized. Recognizing this, one would expect central bankers throughout the world to abandon their feigned aura of a high priesthood of empowered market magicians and confess their ignorance and fallibility.