Monetary Policy and Bond Prices with Drifting Equilibrium Rates
37 Pages Posted: 15 Oct 2020 Last revised: 17 Oct 2020
Date Written: October 4, 2020
We propose a framework that reconciles drifting monetary policy and bond prices with stationary and predictable bond returns. Bond prices are drifting because they reflect the drift in average expected monetary policy rates over the life of the bonds. In our framework, deviations of bond prices from their drift should be stationary and can originate from term premia or temporary deviations from rational expectations in a behavioral framework. Empirically, modeling the drift in monetary policy rates using demographics and productivity trends, and expected long-term inflation, leads to stationary deviations of bond prices from their drift that predict future bond returns.
Keywords: Monetary Policy Rule, Sovereign Bond Yields, Term Structure, Drifting Equilibrium Rate Drivers, Return Predictability
JEL Classification: E43, E52, G12, J11
Suggested Citation: Suggested Citation