Working Paper: CEPR ID: DP14201
Authors: Josh Davis; Cristian Fuenzalida; Alan M. Taylor
Abstract: Benchmark finance models deliver estimates of bond risk premia based on components of Treasury bond yields. Benchmark macroeconomic models deliver estimates of the natural rate of interest based on growth, inflation, and other macro factors. But estimates of the natural rate implied by the former are wildly inconsistent with those of the latter; and estimates of risk premia implied by the latter are wildly inconsistent with those of the former. This is the natural rate puzzle, and we show that it applies not only in the United States but also across several advanced economies. A unified model should not fail such consistency tests. We estimate a unified macro-finance model with long-run trend factors which delivers paths for a market-implied natural rate r* consistent with inflation expectations π* and bond risk premia. These paths are plausible and our factors improve the explanatory power of yield and return regressions. Trading strategies based on signals incorporating both r* and π* trends outperform both yield- only strategies like level and slope and strategies which only add trend inflation. The estimates from our unified model satisfy consistency and deliver a resolution to the puzzle. They show that most of the variation in yields has come from shifts in r* and π*, not from bond risk premia. Our market-implied natural rate differs from consensus estimates, and is typically lower, intensifying concerns about secular stagnation and proximity to the effective lower-bound on monetary policy in advanced economies.
Keywords: Bond Risk Premia; Natural Rate of Interest; Inflation Expectations; Term Structure; Affine Models
JEL Codes: C13; C32; E43; E44; E47; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| natural rate estimates from macroeconomic models (E19) | natural rate estimates from finance models (E43) |
| shifts in the natural rate (r) (E43) | variations in bond yields (E43) |
| natural rate (r) and trend inflation (E31) | trading strategies (G13) |
| unified model (C30) | consistent estimates of the natural rate (E39) |
| natural rate estimates (E43) | alignment with inflation expectations and bond risk premia (E31) |