Nominal Rigidities and the Term Structures of Equity and Bond Returns

42 Pages Posted: 11 May 2023

See all articles by Pierlauro Lopez

Pierlauro Lopez

Federal Reserve Bank of Cleveland

David Lopez-Salido

Board of Governors of the Federal Reserve System

Francisco Vazquez-Grande

Board of Governors of the Federal Reserve System

Date Written: May 11, 2023

Abstract

We present a production economy with nominal price rigidities that explains several asset pricing facts, including a downward-sloping term structure of the equity premium, upward sloping term structures of nominal and real interest rates, and the cyclical variation of the term structures. In the model, after a productivity shock a countercyclical labor share exacerbates the procyclicality of dividends, and hence their riskiness, and generates countercyclical inflation. The dividend share gradually increases after a negative productivity shock as the price level increases sluggishly, so the payoffs of short-duration dividend claims (bonds) are more (less) procyclical than the payoffs of long-duration claims (bonds). A slow-moving external habit then produces large and countercyclical prices for these risks as well as high risk premia at very long horizons. In bad times, the slope of equity (bond) yields for the observable maturities becomes more negative (more positive), but risk premia also increase at longer horizons, and market equity premia end up increasing by more than short-run equity premia. The simultaneous presence of market and home consumption habits allows for uniting habits and a production economy without compromising the model’s ability to fit macroeconomic variables. The central bank’s anti-inflationary stance plays a key role in shaping equity and bond prices.

Keywords: Structural term structure modeling, Equity and bond yields, Habit formation, Nominal rigidities, Macro-finance separation

JEL Classification: E43, E44, G12

Suggested Citation

Lopez, Pierlauro and Lopez-Salido, David and Vazquez-Grande, Francisco, Nominal Rigidities and the Term Structures of Equity and Bond Returns (May 11, 2023). FRB of Cleveland Working Paper No. 23-11, https://doi.org/10.26509/frbc-wp-202311, Available at SSRN: https://ssrn.com/abstract=4445349 or http://dx.doi.org/10.2139/ssrn.4445349

Pierlauro Lopez (Contact Author)

Federal Reserve Bank of Cleveland ( email )

East 6th & Superior
Cleveland, OH 44101-1387
United States

David Lopez-Salido

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Francisco Vazquez-Grande

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States
202-973-7488 (Phone)

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