Interest Rates under Falling Stars
Michael D. Bauer
Glenn D. Rudebusch
- American Economic Review (Forthcoming)
Macro-finance theory implies that trend in
ation and the equilibrium real interest rate are fundamental determinants of the yield
curve. However, empirical models of the term structure of interest rates generally assume that these fundamentals are constant.
We show that accounting for time variation in these underlying
long-run trends is crucial for understanding the dynamics of Treasury yields and predicting excess bond returns. We introduce a
new arbitrage-free model that captures the key role that long-run
trends play in determining interest rates. The model also provides
new, more plausible estimates of the term premium and accurate
out-of-sample yield forecasts.
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