Michael D. Bauer

Monetary Policy Expectations at the Zero Lower Bound

Obtaining monetary policy expectations from the yield curve is difficult near the zero lower bound (ZLB). Standard dynamic term structure models, which ignore the ZLB, can be misleading. Shadow-rate models are better suited for this purpose, because they account for the distributional asymmetry in projected short rates induced by the ZLB. Besides providing better interest rate fit and forecasts, our shadow-rate models deliver estimates of the future monetary policy liftoff from the ZLB that are closer to survey expectations. We also document significant improvements for inference about monetary policy expectations when macroeconomic factors are included in the term structure model.

Term Premia and the News

How do monetary policy expectations and term premia respond to news? This paper provides new answers to this question by means of a dynamic term structure model (DTSM) in which risk prices are restricted. This leads to more precise and more reliable estimates of expectations and term premium components. I provide a new econometric framework for DTSM estimation that allows the researcher to select plausible constraints from a large set of restrictions, to correctly quantify statistical uncertainty, and to incorporate model uncertainty in the inference about risk pricing. The main empirical result is that under the restrictions favored by the data the expectations component, and not the term premium, accounts for the majority of high-frequency movements of long-term interest rates and for essentially all of their procyclical response to macroeconomic news. At both high and low frequencies, term premia are more stable than implied by a DTSM with unconstrained risk prices. The apparent disconnect between long-term rates and policy rates that has puzzled macroeconomists for some time is resolved by appropriately restricting the risk adjustment in models for bond pricing.

Resolving the Spanning Puzzle in Macro-Finance Term Structure Models

Most existing macro-finance term structure models (MTSMs) appear incompatible with regression evidence of unspanned macro risk. This “spanning puzzle” appears to invalidate those models in favor of new unspanned MTSMs. However, our empirical analysis supports the previous spanned models. Using simulations to investigate the spanning implications of MTSMs, we show that a canonical spanned model is consistent with the regression evidence; thus, we resolve the spanning puzzle. In addition, direct likelihood-ratio tests find that the knife-edge restrictions of unspanned models are rejected with high statistical significance, though these restrictions have only small effects on cross-sectional fit and estimated term premia.

Restrictions on Risk Prices in Dynamic Term Structure Models

Restrictions on the risk-pricing in dynamic term structure models (DTSMs) tighten the link between cross-sectional and time-series variation of interest rates, and make absence of arbitrage useful for inference about expectations. This paper presents a new econometric framework for estimation of affine Gaussian DTSMs under restrictions on risk prices, which addresses the issues of a large model space and of model uncertainty using a Bayesian approach. A simulation study demonstrates the good performance of the proposed method. Data for U.S. Treasury yields calls for tight restrictions on risk pricing: only level risk is priced, and only changes in the slope affect term premia. Incorporating the restrictions changes the model-implied short-rate expectations and term premia. Interest rate persistence is higher than in a maximally-flexible model, hence expectations of future short rates are more variable--restrictions on risk prices help resolve the puzzle of implausibly stable short-rate expectations in this literature. Consistent with survey evidence and conventional macro wisdom, restricted models attribute a large share of the secular decline in long-term interest rates to expectations of future nominal short rates.This paper performs Bayesian estimation of affine Gaussian dynamic term structure models (DTSMs) in which the risk price parameters are restricted. A new econometric framework for DTSM estimation allows the researcher to select plausible constraints from a large set of restrictions, to correctly quantify statistical uncertainty, and to incorporate model uncertainty. The main empirical result is that under the restrictions favored by the data the expectations component, and not the term premium, accounts for the majority of high-frequency movements of long-term interest rates. At lower frequencies, term premia are counter-cyclical and more stable than implied by DTSMs without risk price

Inflation Expectations and the News

This paper provides new evidence on the importance of inflation expectations for variation in nominal interest rates, based on both market-based and survey-based measures of inflation expectations. Using the information in TIPS breakeven rates and inflation swap rates, I document that movements in inflation compensation are important for explaining variation in long-term nominal interest rates, both unconditionally as well as conditionally on macroeconomic data surprises. Daily changes in inflation compensation and changes in long-term nominal rates generally display a close statistical relationship. The sensitivity of inflation compensation to macroeconomic data surprises is substantial, and it explains a sizable share of the macro response of nominal rates. The paper also documents that survey expectations of inflation exhibit significant comovement with variation in nominal interest rates, as well as significant responses to macroeconomic news.

Nominal Interest Rates and the News

How do interest rates react to news? This paper presents a new methodology, based on a simple dynamic term structure model, which provides for an integrated analysis of the effects of monetary policy actions and macroeconomic news on the term structure of interest rates. I find several new empirical results: First, monetary policy directly affects distant forward rates. Second, policy news is more complex than macro news. Third, while payroll news causes the most action in interest rates, it does not affect distant forward rates. Fourth, the term structure response to macro news is consistent with considerable interest rate smoothing.

Robust Bond Risk Premia

A consensus has recently emerged that a number of variables in addition to the level, slope, and curvature of the term structure can help predict interest rates and excess bond returns. We demonstrate that the statistical tests that have been used to support this conclusion are subject to very large size distortions from a previously unrecognized problem arising from highly persistent regressors and correlation between the true predictors and lags of the dependent variable. We revisit the evidence using tests that are robust to this problem and conclude that the current consensus is wrong. Only the level and the slope of the yield curve are robust predictors of excess bond returns, and there is no robust and convincing evidence for unspanned macro risk.