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Long-Run Inflation Risk and the Postwar Term Premium

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  • Eric Swanson

    (Federal Reserve Bank of San Francisco)

  • Glenn Rudebusch

    (Federal Reserve Bank of San Francisco)

Abstract

Long-term bond yields in the U.S. steadily rose during the 1960s and 1970s and then retreated over the next two decades. This rise and fall is difficult to explain using only changes in long-term inflation expectations and real interest rates; instead, an additional role for changes in the term premium--the risk premium on long-term bonds--appears to be required. We explain the behavior of long-term bond yields with a New Keynesian DSGE model with nominal rigidities, Epstein-Zin-Weil preferences, and long-run inflation risk. We show that this model--unlike many others--is able to generate an empirically plausible level of the term premium without compromising the model's ability to fit key macroeconomic variables. Moreover, by taking into account changes in the Federal Reserve's perceived commitment to a low long-term U.S. inflation rate, the model's predictions for inflation expectations and the term premium are able to explain the behavior of U.S. long-term bond yields in the postwar period.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2008 Meeting Papers with number 988.

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Date of creation: 2008
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Handle: RePEc:red:sed008:988

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  1. Olivier Blanchard & Jordi Galí, 2005. "Real wage rigidities and the new Keynesian model," Economics Working Papers, Department of Economics and Business, Universitat Pompeu Fabra 912, Department of Economics and Business, Universitat Pompeu Fabra, revised Oct 2005.
  2. Michael F. Gallmeyer & Burton Hollifield, 2005. "Taylor Rules, McCallum Rules and the Term Structure of Interest Rates," 2005 Meeting Papers, Society for Economic Dynamics 676, Society for Economic Dynamics.
  3. Glenn D. Rudebusch & Eric T. Swanson, 2008. "Examining the bond premium puzzle with a DSGE model," Working Paper Series, Federal Reserve Bank of San Francisco 2007-25, Federal Reserve Bank of San Francisco.
  4. Christopher J. Erceg & Dale W. Henderson & Andrew T. Levin, 1999. "Optimal monetary policy with staggered wage and price contracts," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 640, Board of Governors of the Federal Reserve System (U.S.).
  5. Noah Williams & Andrew Levin & Alexei Onatski, 2005. "Monetary Policy under Uncertainty in Micro-Founded Macroeconometric Models," Computing in Economics and Finance 2005, Society for Computational Economics 478, Society for Computational Economics.
  6. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, Elsevier, vol. 12(3), pages 383-398, September.
  7. Campbell, John Y & Shiller, Robert J, 1991. "Yield Spreads and Interest Rate Movements: A Bird's Eye View," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 58(3), pages 495-514, May.
  8. Refet S. Gürkaynak & Brian Sack & Eric Swanson, 2005. "The Sensitivity of Long-Term Interest Rates to Economic News: Evidence and Implications for Macroeconomic Models," American Economic Review, American Economic Association, American Economic Association, vol. 95(1), pages 425-436, March.
  9. Michele Boldrin & Lawrence J. Christiano & Jonas D.M. Fisher, 1999. "Habit persistence, asset returns and the business cycles," Working Paper Series, Federal Reserve Bank of Chicago WP-99-14, Federal Reserve Bank of Chicago.
  10. Ravi Bansal & Amir Yaron, 2004. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," Journal of Finance, American Finance Association, American Finance Association, vol. 59(4), pages 1481-1509, 08.
  11. Thomas Tallarini, . "Risk-Sensitive Real Business Cycles," GSIA Working Papers, Carnegie Mellon University, Tepper School of Business 1997-35, Carnegie Mellon University, Tepper School of Business.
  12. Eric Swanson & Gary Anderson & Andrew Levin, 2006. "Higher-order perturbation solutions to dynamic, discrete-time rational expectations models," Working Paper Series, Federal Reserve Bank of San Francisco 2006-01, Federal Reserve Bank of San Francisco.
  13. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, Elsevier, vol. 41(2), pages 257-275, April.
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Cited by:
  1. Mehmet Pasaogullari & Simeon Tsonevy, 2011. "The term structure of inflation compensation in the nominal yield curve," Working Paper, Federal Reserve Bank of Cleveland 1133, Federal Reserve Bank of Cleveland.

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