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Expectations, Bond Yields and Monetary Policy

Review of Financial Studies, October 1, 2010

AFA 2006 Boston Meetings Paper

EFA 2007 Ljubljana Meetings Paper

44 Pages Posted: 19 Mar 2005 Last revised: 29 Nov 2010

Albert Lee Chun

University of Queensland - Business School; Rensselaer Polytechnic Institute (RPI) - Lally School of Management & Technology

Date Written: November 28, 2010

Abstract

Through explicitly incorporating analysts' forecasts as observable factors in a dynamic arbitrage-free model of the yield curve, this research proposes a framework for studying the impact of shifts in market sentiment on interest rates of all maturities. An empirical examination reveals that survey expectations about inflation, output growth, and the anticipated path of monetary policy actions contain important information for explaining movements in bond yields. Estimates from a forward-looking monetary policy rule suggest that the central bank exhibits a preemptive response to inflationary expectations while accommodating output growth and monetary policy expectations. Forecasted GDP growth plays a significant role in explaining time variation in the market prices of risk. The sensitivity of long yields is linked to the persistence of expected inflation under the risk-neutral measure. Models of this type may provide traders and policymakers with a new set of tools for formally assessing the reaction of bond yields to shifts in market expectations.

Keywords: term structure, interest rates, affine model, forward-looking policy rules, macro-finance, no-arbitrage, blue chip forecasts, survey data

JEL Classification: E40, E43, E44, G12, D84, E52, E58

Suggested Citation

Chun, Albert Lee, Expectations, Bond Yields and Monetary Policy (November 28, 2010). Review of Financial Studies, October 1, 2010 ; AFA 2006 Boston Meetings Paper; EFA 2007 Ljubljana Meetings Paper. Available at SSRN: https://ssrn.com/abstract=685801 or http://dx.doi.org/10.2139/ssrn.685801

Albert Lee Chun (Contact Author)

University of Queensland - Business School ( email )

Rensselaer Polytechnic Institute (RPI) - Lally School of Management & Technology ( email )

110 8th St
Troy, NY 12180
United States

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