Back to the 1980s or Not? The Drivers of Inflation and Real Risks in Treasury Bonds

Abstract

I use nominal and real bond risks as new moments to discipline a New Keynesian asset pricing model, where supply shocks, demand shocks, and monetary policy are the fundamental drivers of inflation. Endogenously time-varying risk premia imply that nominal bond risks—as measured by their stock market beta—are a forward-looking indicator of stagflation risks. Calibrating the model separately for the 1980s and the 2000s, I show that positive nominal bond betas in the 1980s resulted from a “perfect storm” of supply shocks and a reactive monetary policy rule, but not from either supply shocks or monetary policy in isolation.

Keywords: inflation, risk premia, bond return predictability, stagflation, monetary policy

JEL Classification: E0,E31,E40,G10,G12