Long-Run Inflation Risk and the Postwar Term Premium

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.