This paper presents an essentially affine model of the term structure of interest rates making use of macroeconomic factors and their long-run expectations. The model extends the approach pioneered by Kozicki and Tinsley (2001) by modeling consistently long-run inflation expectations simultaneously with the term structure. This model thus avoids the standard pre-filtering of long-run expectations, as proposed by Kozicki and Tinsley (2001). Application to the U.S. economy shows the importance of long-run inflation expectations in the modelling of long-term bonds. The paper also provides a macroeconomic interpretation for the factors found in a latent factor model of the term structure. More specifically, we find that the standard "level" factor is highly correlated to long-run inflation expectations, the "slope" factor captures temporary business cycle conditions, while the "curvature" factor represents a clear independent monetary policy factor.
This paper presents an essentially affine model of the term structure of interest rates making use of macroeconomic factors and their long-run expectations. The model extends the approach pioneered by Kozicki and Tinsley (2001) by modeling consistently long-run inflation expectations simultaneously with the term structure. Application to the U.S. economy shows the importance of long-run inflation expectations in the modeling of long-term bond yields. The paper also provides a macroeconomic interpretation for the latent factors found in standard finance models of the yield curve: the level factor represents the long-run inflation expectation of agents; the slope factor captures business cycle conditions; and the curvature factor expresses a clear independent monetary policy factor.
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; the European Central Bank; and the University of Warwick for useful discussions and comments on a previous version of this chapter. The authors are responsible for remaining errors.
We present and estimate a continuous time term structure model that incorporates observable macroeconomic variables and latent variables with a clear macroeconomic interpretation. Our model is able to accurately describe the joint dynamics for US macroeconomic variables and the yield curve. However, the observable variables do not explain the long end of the term structure. Central tendencies of these macroeconomic variables do a much better job in this respect. These unobservable factors also play an important role in the description of the interest rate policy rule. Both observable and non-observable factors determine the risk premia and hence bond excess holding returns. Copyright © 2006 John Wiley & Sons, Ltd.
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