2017-16 | November 2017
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Interest Rates Under Falling Stars
While theory predicts that the equilibrium real interest rate, r*, and the perceived trend in inflation, pi*, 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.
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Bauer, Michael D, and Glenn D. Rudebusch. 2017. "Interest Rates Under Falling Stars," Federal Reserve Bank of San Francisco Working Paper 2017-16. Available at https://doi.org/10.24148/wp2017-16