Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Inflation Uncertainty and the Recent Low Level of the Long Bond Rate

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Inflation Uncertainty and the Recent Low Level of the Long Bond Rate

Article excerpt

(ProQuest Information and Learning: ... denotes formulae omitted.)

Many analysts and policymakers have been intrigued by the recently observed low levels of long-term interest rates. Figure 1 charts the actual and predicted levels of the nominal yield on ten-year U.S. Treasury bonds over 1994Q1 to 2005Q1; the predicted values were generated using the historical relationship that had existed between the long bond yield and several of its macroeconomic determinants including long-term inflation expectations, near-term outlook for the economy, and the stance of monetary policy. The prediction errors are also charted there. As one can see, for the past few years the actual long bond rate has remained consistently below what is predicted using these standard economic determinants.1 Other analysts using somewhat different economic determinants have come to the same conclusion that the long bond rate has recently been substantially lower than can be explained by macroeconomic conditions.2

In order to explain the recent puzzling behavior of long-term interest rates, two alternative hypotheses have received prominent attention in the financial press.3 The first one attributes the current low level of the long bond rate to the lowering of the inflation risk premium. In particular, this hypothesis posits that as a result of the improved inflation performance of the U.S. economy, inflation uncertainty has declined, leading to lowering of inflation risk premiums, which is reflected in lower real and nominal bond yields.4 The other hypothesis attributes recent declines in long-term interest rates to increases in purchases of U.S. Treasury securities by foreign central banks.5

This article develops an empirical test of the first hypothesis, using a reduced-form interest rate equation that links the long bond rate directly to macroeconomic variables, including an empirical proxy for inflation uncertainty. I focus on the first hypothesis for two reasons. First, despite the popularity of the first hypothesis in the financial press, it has not yet been formally investigated. In most previous research, the evidence in favor of the first hypothesis comes from the term structure model, indicating that term premiums have declined and that part of this decline is attributed to a decline in the inflation risk premium. This article, however, constructs a direct empirical measure of inflation uncertainty and examines whether the recent behavior of the long bond rate can be linked to the recent reduction in inflation uncertainty. Second, some previous research has indicated that the empirical evidence favoring the second hypothesis is fragile in the sense that the empirical evidence-the long bond rate is influenced by direct foreign capital inflows-is due to the most recent data.6 In view of these considerations, I focus on the first hypothesis, but I do examine the robustness of results with respect to inclusion of foreign official purchases of U.S. Treasury securities in the list of macroeconomic determinants.

It is widely understood that investors holding long-term U.S. Treasury bonds bear an inflation risk, because actual inflation that is higher or lower than what they forecasted when they bought bonds would make their holding of bonds significantly less or more valuable. Hence, if there is considerable uncertainty about long-term inflation forecasts in the sense that the probability distribution of long-term inflation forecasts is widely dispersed, investors demand compensation for bearing the inflation risk, and hence long bond rates contain risk premiums.

Since we do not have a direct empirical measure of uncertainty about long-term inflation forecasts, this article constructs an empirical proxy making two identifying assumptions. The first assumption is that uncertainty about long-term inflation forecasts is positively correlated with uncertainty about short-term inflation forecasts, so that when investors become more uncertain about their short-term inflation forecasts, their uncertainty about long-term inflation forecasts also increases. …

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