2017-16 | July 2017
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Interest Rates Under Falling Stars
Theory predicts that the equilibrium real interest rate, r*, and the perceived trend in inflation, pi*, are key determinants of the term structure of interest rates. However, term structure analyses generally assume that these endpoints are constant. Instead, we show that allowing for time variation in both r* and pi* is crucial for understanding the empirical dynamics of U.S. Treasury yields and risk pricing. Our evidence reveals that accounting for fluctuations in both r* and pi* substantially increases the accuracy of long-range interest rate forecasts, helps predict excess bond returns, improves estimates of the term premium in long-term interest rates, and captures a substantial share of interest rate variability at low frequencies.
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Bauer, Michael D, and Glenn D. Rudebusch. 2017. "Interest Rates Under Falling Stars," FRB San Francisco Working Paper 2017-16. Available at https://doi.org/10.24148/wp2017-16