Expectations, Bond Yields and Monetary Policy

Abstract:     
Through explicitly incorporating analysts' forecasts as observable factors in a dynamic arbitrage-free model of the yield curve, this research proposes a framework for studying the impact of shifts in market sentiment on interest rates of all maturities. An empirical examination reveals that survey expectations about inflation, output growth, and the anticipated path of monetary policy actions contain important information for explaining movements in bond yields. Estimates from a forward-looking monetary policy rule suggest that the central bank exhibits a preemptive response to inflationary expectations while accommodating output growth and monetary policy expectations. Forecasted GDP growth plays a significant role in explaining time variation in the market prices of risk. The sensitivity of long yields is linked to the persistence of expected inflation under the risk-neutral measure. Models of this type may provide traders and policymakers with a new set of tools for formally assessing the reaction of bond yields to shifts in market expectations.

Number of Pages in PDF File: 44

Keywords: term structure, interest rates, affine model, forward-looking policy rules, macro-finance, no-arbitrage, blue chip forecasts, survey data

JEL Classification: E40, E43, E44, G12, D84, E52, E58

working papers series