The Short-Run Policy Constraints of Long-Run Expectations

Stefano Eusepi, Marc Giannoni and Bruce Preston

Journal of Political Economy, 2026, vol. 134, issue 2, 525 - 569

Abstract: This paper provides theory and evidence that distorted long-term interest rate expectations limit the effectiveness of monetary policy. Beliefs that depart from rational expectations break the tight link between policy rates and long-term interest rates, even when determined by the expectations hypothesis of the yield curve. Because long-term expectations are excessively sensitive to short-term interest rates, optimal policy is less aggressive relative to rational expectations. More aggressive policy leads to suboptimal volatility in long-term interest rates and aggregate demand through standard intertemporal substitution effects. These effects are quantitatively important in the United States over the postwar period.

Date: 2026
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