Endogenous Yield Curve Risk from Central Bank Policy Uncertainty
13 Pages Posted: 4 Dec 2006
Date Written: November 15, 2006
Due to economic feedback the actual risk in bonds from changes in Federal Reserve policy should generally be smaller than measured using conventional duration measures. We introduce the notion of Federal Reserve policy durations. For example, target inflation duration, which measures the change in the price of a treasury bond that arises from a change in Central Bank target inflation rate that occurs at some time in the future before the maturity of the bond. For Central Banks following a policy setting rule such as a Taylor rule, we derive a simple analytic expression for the target inflation duration of zero coupon Treasury bonds in terms of model economic parameters and the parameters in the Taylor rule. The correction to the traditional duration of a zero coupon bond is proportional, at leading order, to the product of three terms: the Taylor rule output gap coefficient, the coefficient in the economy that determines the response of the output gap to the real rate, and the square of the maturity of the zero coupon bond.
Keywords: Central Bank Policy, Duration
JEL Classification: G1, E4, E5
Suggested Citation: Suggested Citation