Monetary Policy and Bond Prices with Drifting Equilibrium Rates and Diagnostic Expectations

51 Pages Posted: 15 Oct 2020 Last revised: 2 Dec 2020

See all articles by Carlo A. Favero

Carlo A. Favero

Bocconi University - Department of Finance; Centre for Economic Policy Research (CEPR)

Alessandro Melone

Vienna Graduate School of Finance (VGSF)

Andrea Tamoni

Rutgers, The State University of New Jersey - Rutgers Business School at Newark & New Brunswick

Date Written: October 4, 2020

Abstract

We propose a framework that reconciles drifting Treasury 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 when the drift is correctly modelled; they can originate from either 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, plus long-term inflation expectations, leads to stationary deviations of bond prices from their drift that predict future bond returns. Through our model, we detect a significant role of temporary deviations from the rational expectations in determining the cyclical properties of yields at all maturities.

Keywords: Monetary Policy Rule, Treasury Bond Yields, Drifting Equilibrium Rate Drivers, Diagnostic Expectations, Bond Return Predictability.

JEL Classification: E43, G12, J11

Suggested Citation

Favero, Carlo A. and Melone, Alessandro and Tamoni, Andrea, Monetary Policy and Bond Prices with Drifting Equilibrium Rates and Diagnostic Expectations (October 4, 2020). Available at SSRN: https://ssrn.com/abstract=3704241 or http://dx.doi.org/10.2139/ssrn.3704241

Carlo A. Favero (Contact Author)

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

HOME PAGE: http://www.igier.unibocconi.it\favero

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Alessandro Melone

Vienna Graduate School of Finance (VGSF) ( email )

WU Vienna
Welthandelsplatz 1
Vienna, 1020
Austria

HOME PAGE: http://https://sites.google.com/view/alessandro-melone/home

Andrea Tamoni

Rutgers, The State University of New Jersey - Rutgers Business School at Newark & New Brunswick ( email )

1 Washington Park
Newark, NJ 07102
United States

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