Monetary Policy and Bond Prices with Drifting Equilibrium Rates and Diagnostic Expectations
51 Pages Posted: 15 Oct 2020 Last revised: 2 Dec 2020
Date Written: October 4, 2020
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: Suggested Citation