The great moderation of the term structure of UK interest rates

The conduct of monetary policy, the term structure of interest rates and the structure of the economy in the UK have changed over the post-WWII period. We model the interaction between the macroeconomy and financial markets using a time-varying VAR augmented with the factors from the yield curve. There is evidence of a great moderation in the dynamics of the yield curve, with the factors being persistent and volatile before the introduction of inflation targeting in 1992 but becoming stable afterwards. The introduction of time-variation in the Factor Augmented VAR improves the fit of the model and results in expectation hypothesis consistent yields that are close to actual yields, even at long maturities. Monetary policy shocks had a significant impact on the volatility of inflation, output and the policy rate over the pre-inflation targeting era, but their contribution has been negligible under the current regime. Shocks to the level of the yield curve accounted for a large fraction of inflation variability only before 1992.