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Numerous studies have used quarterly data to estimate monetary policy rules or reaction functions that appear to exhibit a very slow partial adjustment of the policy interest rate. The conventional wisdom asserts that this gradual adjustment reßects a policy inertia or interest rate smoothing behavior by central banks. However, such quarterly monetary policy inertia would imply a large amount of forecastable variation in interest rates at horizons of more than three months, which is contradicted by evidence from the term structure of interest rates. The illusion of monetary policy inertia evident in the estimated policy rules likely reßects the persistent shocks that central banks face. JEL classiÞcation: E4; E5

We estimate a model that summarizes the yield curve using latent factors (specifically, level, slope, and curvature) and also includes observable macroeconomic variables (specifically, real activity, inflation, and the monetary policy instrument). Our goal is to provide a characterization of the dynamic interactions between the macroeconomy and the yield curve. We find strong evidence of the effects of macro variables on future movements in the yield curve and evidence for a reverse influence as well. We also relate our results to the expectations hypothesis. r

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The term premium on long-term nominal bonds compensates investors for inflation and consumption risks over the lifetime of the bond. A large finance literature finds that these risk premiums are substantial and vary significantly over time (e.g., Campbell and Shiller 1991; Cochrane and Piazzesi 2005); however, the economic forces that can justify such large and variable term premiums are less clear. Piazzesi and Schneider (2007) provide some economic insight into the source of a large positive mean term premium in a consumption-based asset pricing model of an endowment economy. Their analysis relies on two crucial features: first, the structural assumption that investors have Epstein-Zin recursive utility preferences; 1 and second, an estimated reduced-form process for consumption and inflation with the feature that positive inflation surprises lead to lower future consumption growth. With these two elements, they show that investors require a premium for holding nominal bonds because a positive inflation surprise 1 Kreps and Porteus (1978) provide the original theoretical framework for these preferences. Epstein and Zin (1989) and Weil (1989) provide extended results and applications for a special case of this framework.