The Excess Sensitivity of Long-term Interest rates and Central Bank Credibility

Long-term interest rates show considerable reactions to macroeconomic and monetary policy news. It is, however, difficult to be explained by standard rational expectations macro-finance models widely used in policy analyses. In this research, we demonstrate that private¡¯s subjective beliefs and central bank credibility can account for the excess sensitivity of long-term interest rates using an estimated macro-finance model which incorporates private¡¯s subjective perceptions on future real activity and inflation and endogenously evolving central bank credibility. We find that long-term rates respond stronger to macro shocks and shifts in private's perceptions regarding expected real activity and inflation when credibility is lower. In addition, the model simulation shows that 10-year yield varies substantially more when credibility is low.