Demographics and the Behavior of Interest Rates

Abstract

Interest rates are very persistent. Modelling the persistent component of interest rates has important consequences for forecasting. Consider Affine Term Structure Models (ATSM): given the dynamics of the short term rate, a stationary VAR for the factors is used to project the entire term structure. No explanatory variable included in ATSM model is designed to capture the persistent component of spot rates. This omission can explain the disappointing forecasting performance of ATSM models. This paper relates the common persistent component of the U.S. term structure of interest rates to the age composition of population. The composition of age structure determines the equilibrium rate in the monetary policy rule and therefore the persistent component in one-period yields. Fluctuations in demographics are then transmitted to the whole term structure via the expected policy rate components. We build an affine term structure model (ATSM) which exploits demographic information to capture the dynamics of yields and produce useful forecasts of bond yields and excess returns that provides economic value for long-term investors.

Keywords: demographics, term-structure models, forecasting, economic value

JEL Classification: C33, C53, E43, E44, J11