Macro Factors and the Term Structure of Interest Rates

Abstract

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.

Keywords: Essentially affine term structure model, macroeconomic factors, long-run market expectations, monetary policy rule

JEL Classification: M, M41, G3, E43, E44, E52