Many interpret estimated monetary policy rules as suggesting that central banks conduct very sluggish partial adjustment of short-term policy interest rates. In contrast, others argue that this appearance of policy inertia is an illusion and simply reflects the spurious omission of important persistent influences on the actual setting of policy. Similarly, the real-world implications of the theoretical arguments for policy inertia are open to debate. However, empirical evidence on policy gradualism obtained by examining expectations of future monetary policy embedded in the term structure of interest rates is definitive and indicates that the actual amount of policy inertia is quite low.

The basic inability of standard theoretical models to generate a sufficiently large and variable nominal bond risk premium has been termed the “bond premium puzzle.” We show that the term premium on long-term bonds in the canonical dynamic stochastic general equilibrium (DSGE) model used in macroeconomics is too small and stable relative to the data. We find that introducing long-memory habits in consumption as well as labor market frictions can help fit the term premium, but only by seriously distorting the DSGE model’s ability to fit other macroeconomic variables, such as the real wage; therefore, the bond premium puzzle remains.

Linearized New Keynesian models and empirical no-arbitrage macro-finance models offer little insight regarding the implications of changes in bond term premiums for economic activity. This paper investigates these implications using both a structural model and a reduced-form framework. The authors show that there is no structural relationship running from the term premium to economic activity, but a reduced-form empirical analysis does suggest that a decline in the term premium has typically been associated with stimulus to real economic activity, which contradicts earlier results in the literature.

From 2004 to 2006, the FOMC raised the target federal funds rate by 4.25%, yet long-maturity yields and forward rates fell. We consider several possible explanations for this “conundrum. ” The most likely, in our view, is a fall in the term premium, probably associated with some combination of diminished macroeconomic and financial market volatility, more predictable monetary policy, and the state of the business cycle.

As baby boomers reach retirement age, concerns over the future path of federal spending on entitlement programs grows among orthodox economists. Researchers closely tied to the “generational accounting ” literature (i.e., Kotlikoff, 1992) have been particularly prominent here. These economists have developed a measure that they call the “fiscal imbalance”—which they claim measures the magnitude of an existing unsustainable fiscal path. They argue that the fiscal path of the U.S. is $44 trillion off course compared to a “sustainable ” path (Gokhale and Smetters, 2003a). Others within the circle have noted the $44 trillion “fiscal imbalance ” in numerous opinion pieces (e.g., Gokhale and Smetters, 2003b; Kotlikoff and Sachs, 2003) and in other publications (e.g., Ferguson and Kotlikoff, 2003; Kotlikoff and Burns, 2004). An essentially identical measure expressing the imbalance as a percent of future GDP—the “fiscal gap ” (e.g., Auerbach, 1994)—shows it to be about 7 percent (e.g., Auerbach et al., 2003). The “fiscal imbalance ” is calculated as the current national debt plus the present value of future expenditures less the present value of future revenues; future expenditures and revenues are estimated or predicted to the infinite horizon (Gokhale and Smetters, 2003a; Auerbach et al., 2003). The widely-cited 2003 study by Jagadeesh Gokhale and Kent Smetters was originally commissioned by then-Treasury Secretary Paul O’Neill in 2002, when its authors were deputy assistant secretary for economic policy at the Treasury (Smetters) and consultant to the Treasury (Gokhale), respectively. However, the Bush Administration played down the results of the report as it prepared in late 2002 and early 2003 to promote a second round of tax cuts (Despeignes, 2003). Nonetheless, measuring a “fiscal imbalance ” via an identical methodology has since been promoted by others in the Office of Management and the Budget (2005), the Treasury (e.g., Fisher, 2003), the IMF (e.g., Mühleisen and Towe, 2004), and has also been incorporated into projections of the Trustees for Social Security and Medicare. A final example is worth

This paper examines empirically whether foreign holdings of U.S. Treasury securities are relevant to explaining U.S. Treasury yields. Interest in this topic is motivated by the failure of the long-term interest rate to rise during 2004-2005 in response to increases in the short-term rate, a phenomenon that took place against a backdrop of rapidly rising foreign holdings of U.S. securities and declining foreign interest rates. There are not many papers examining this question and the little evidence available o¤ers no agreement on whether holdings of U.S. Treasuries a¤ect U.S. long-term interest rates. What is not clear is what is responsible for it. We requested their data, replicated their results, and found them to be sensitive to minor changes. Our strategy is to re-examine the association by extending the framework used in previous work. Speci…cally, previous work does not recognize that foreigners can redirect their …nancial holdings anywhere in the world with e¤ects on world interest rates. We address these limitations using a variety of vantage points: single-equation, Vector Error-correction models, yield-curve models, and DSGE models. The evidence suggests that foreign holdings of U.S. securities help explaining movements in U.S. Treasury yields. We have bene…ted from conversations with Carol Bertaut, Stephanie Curcuru, Michiel De Pooter, Neil Ericsson, and Siem

This paper provides an overview of the analysis of the term structure of interest rates with a special emphasis on recent developments at the intersection of macroeconomics and finance. The topic is important to investors and also to policymakers, who wish to extract macroeconomic expectations from longer-term interest rates, and take actions to influence those rates. The simplest model of the term structure is the expectations hypothesis, which posits that long-term interest rates are expectations of future average short-term rates. In this paper, we show that many features of the con…guration of interest rates are puzzling from the perspective of the expectations hypothesis. We review models that explain these anomalies using time-varying risk premia. Although the quest for the fundamental macroeconomic explanations of these risk premia is ongoing, in‡ation uncertainty seems to play a large role. Finally, while modern finance theory prices bonds and other assets in a single unified framework, we also consider an earlier approach based on segmented markets. Market segmentation seems important to understand the term structure of interest rates during the recent financial crisis.

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Offshore markets for the domestic currency: monetary and financial stability issues

Affine-term-structure models have been used to address a wide range of questions in macroeconomics and finance. This paper investigates a number of their testable implications which have not previously been explored. We show that the assumption that certain specified yields are priced without error is testable, and find that the implied measurement or specification error on other yields exhibits serial correlation in all of the possible formulations investigated here. We further find that the predictions of these models for the average levels of different interest rates are inconsistent with the observed data, and propose a more general specification that is not rejected by the data.