Interest Rates Under Falling Stars

Abstract

While theory predicts that the equilibrium real interest rate, $r^\ast_t$, and the perceived trend in inflation, $\pi^\ast_t$, are fundamental determinants of the yield curve, macro-finance models generally treat them as constant. We show that accounting for time-varying macro trends is critical for understanding the empirical dynamics of U.S. Treasury yields and risk pricing. It fundamentally changes estimated risk premiums in long-term bond yields, leads to large gains in predictions of excess bond returns and long-range out-of-sample forecasts of interest rates, and captures a substantial share of interest rate variability at low frequencies.

Publication
Federal Reserve Bank of San Francisco Working Paper Series
Date
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