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Reading the minds of investors: an empirical term structure model for policy analysis

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  • Jim Clouse
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    Abstract

    Building on the recent macro finance literature, this paper develops an empirical term structure model in which investors' judgmental forecasts of macro variables play an important role. The model allows for a limited form of time-variation in the dynamics describing the behavior of short-term interest rates and macro variables. As a result, changes in economic forecasts over time reflect the influence of both economic shocks and perceived changes in economic structure. The latter, in particular, are shown to be important in explaining the evolution of the yield curve over time. An interest rate accounting framework based on the model is applied in parsing changes in long-term interest rates into portions associated with changes in term premiums and changes in expected future short-rates. The changes in expected future short rates are then further decomposed into portions attributable to changes in the expected future paths for inflation, the unemployment rate, and GDP growth and also to a fourth factor interpreted as changes in the "stance of monetary policy." The model results indicate that changes in long-term interest rates, on average, have been about equal parts changes in term premia and changes in expected future short rates. Changes in expected future short rates seem to be driven largely by changes in the stance of monetary policy and in the outlook for inflation while the estimated influence of changes in the outlook for the unemployment rate and GDP growth is more muted.

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    Bibliographic Info

    Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2004-64.

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    Date of creation: 2004
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    Handle: RePEc:fip:fedgfe:2004-64

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    Related research

    Keywords: Econometric models ; Economic forecasting ; Interest rates ; Economic indicators;

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    References

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    1. Ang, Andrew & Piazzesi, Monika & Wei, Min, 2006. "What does the yield curve tell us about GDP growth?," Journal of Econometrics, Elsevier, vol. 131(1-2), pages 359-403.
    2. Lars E.O. Svensson, 1994. "Estimating and Interpreting Forward Interest Rates: Sweden 1992 - 1994," NBER Working Papers 4871, National Bureau of Economic Research, Inc.
    3. Charles L. Evans & David Marshall, 2001. "Economic determinants of the nominal treasury yield curve," Working Paper Series WP-01-16, Federal Reserve Bank of Chicago.
    4. GlennD. Rudebusch & Tao Wu, 2008. "A Macro-Finance Model of the Term Structure, Monetary Policy and the Economy," Economic Journal, Royal Economic Society, vol. 118(530), pages 906-926, 07.
    5. Sharon Kozicki & P.A. Tinsley, 1997. "Shifting endpoints in the term structure of interest rates," Research Working Paper 97-08, Federal Reserve Bank of Kansas City.
    6. Ang, Andrew & Piazzesi, Monika, 2003. "A no-arbitrage vector autoregression of term structure dynamics with macroeconomic and latent variables," Journal of Monetary Economics, Elsevier, vol. 50(4), pages 745-787, May.
    7. James A. Kahn & Margaret M. McConnell & Gabriel Perez-Quiros, 2002. "On the causes of the increased stability of the U.S. economy," Economic Policy Review, Federal Reserve Bank of New York, issue May, pages 183-202.
    8. Fuhrer, Jeffrey C, 1996. "Monetary Policy Shifts and Long-Term Interest Rates," The Quarterly Journal of Economics, MIT Press, vol. 111(4), pages 1183-1209, November.
    9. James H. Stock & Mark W. Watson, 2002. "Has the Business Cycle Changed and Why?," NBER Working Papers 9127, National Bureau of Economic Research, Inc.
    10. Ben S. Bernanke & Vincent R. Reinhart & Brian P. Sack, 2004. "Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 35(2), pages 1-100.
    11. Refet S. G├╝rkaynak & Brian Sack & Eric Swanson, 2003. "The excess sensitivity of long-term interest rates: evidence and implications for macroeconomic models," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
    12. Donald L. Kohn & Brian P. Sack, 2003. "Central bank talk: does it matter and why?," Finance and Economics Discussion Series 2003-55, Board of Governors of the Federal Reserve System (U.S.).
    13. Qiang Dai & Kenneth Singleton, 2003. "Term Structure Dynamics in Theory and Reality," Review of Financial Studies, Society for Financial Studies, vol. 16(3), pages 631-678, July.
    14. Peter Hordahl & Oreste Tristani & David Vestin, 2003. "A joint econometric model of macroeconomic and term structure," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
    15. Lars E. O. Svensson, 1994. "Estimating and Interpreting Forward Interest Rates," IMF Working Papers 94/114, International Monetary Fund.
    16. Shiller, Robert J, 1979. "The Volatility of Long-Term Interest Rates and Expectations Models of the Term Structure," Journal of Political Economy, University of Chicago Press, vol. 87(6), pages 1190-1219, December.
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    Cited by:
    1. Yash P. Mehra, 2006. "Inflation uncertainty and the recent low level of the long bond rate," Economic Quarterly, Federal Reserve Bank of Richmond, issue Sum, pages 225-253.

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