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Interest Rates Under Falling Stars

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Theory predicts that the equilibrium real interest rate, r*, and the perceived trend in inflation, pi*, are key determinants of the term structure of interest rates. However, term structure analyses generally assume that these endpoints are constant. Instead, we show that allowing for time variation in both r* and pi* is crucial for understanding the empirical dynamics of U.S. Treasury yields and risk pricing. Our evidence reveals that accounting for fluctuations in both r* and pi* substantially increases the accuracy of long-range interest rate forecasts, helps predict excess bond returns, improves estimates of the term premium in long-term interest rates, and captures a substantial share of interest rate variability at low frequencies.

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Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2017-16.

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Length: 47 pages
Date of creation: 10 Jul 2017
Handle: RePEc:fip:fedfwp:2017-16
DOI: 10.24148/wp2017-16
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  7. Dewachter, Hans & Iania, Leonardo, 2012. "An Extended Macro-Finance Model with Financial Factors," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 46(06), pages 1893-1916, February.
  8. Rachel, Lukasz & Smith, Thomas, 2015. "Secular drivers of the global real interest rate," Bank of England working papers 571, Bank of England.
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  12. 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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