Working Paper: NBER ID: w13245
Authors: Michael F. Gallmeyer; Burton Hollifield; Francisco Palomino; Stanley E. Zin
Abstract: We examine the relationship between monetary-policy-induced changes in short interest rates and yields on long-maturity default-free bonds. The volatility of the long end of the term structure and its relationship with monetary policy are puzzling from the perspective of simple structural macroeconomic models. We explore whether richer models of risk premiums, specifically stochastic volatility models combined with Epstein-Zin recursive utility, can account for such patterns. We study the properties of the yield curve when inflation is an exogenous process and compare this to the yield curve when inflation is endogenous and determined through an interest-rate/Taylor rule. When inflation is exogenous, it is difficult to match the shape of the historical average yield curve. Capturing its upward slope is especially difficult as the nominal pricing kernel with exogenous inflation does not exhibit any negative autocorrelation - a necessary condition for an upward sloping yield curve as shown in Backus and Zin (1994). Endogenizing inflation provides a substantially better fit of the historical yield curve as the Taylor rule provides additional flexibility in introducing negative autocorrelation into the nominal pricing kernel. Additionally, endogenous inflation provides for a flatter term structure of yield volatilities which better fits historical bond data.
Keywords: monetary policy; yield curve; stochastic volatility; risk premiums; Epstein-Zin utility
JEL Codes: E43; E44; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Changes in short-term interest rates (E43) | Fluctuations in long-term interest rates (E43) |
| Expectations of future short rates (E43) | Fluctuations in long-term interest rates (E43) |
| Stochastic risk premiums (G19) | Fluctuations in long-term interest rates (E43) |
| Endogenous inflation process (E31) | Term structure of interest rates (E43) |
| Monetary policy (E52) | Term structure of interest rates (E43) |
| Monetary policy (E52) | Risk premium associated with long-term bonds (G12) |
| Inflation expectations (E31) | Bond pricing (G12) |
| Recursive utility model with stochastic volatility (C69) | Risk premiums (G19) |
| Effective monetary policy (E52) | Yield volatility and risk premiums (G17) |