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Monetary Policy and Bond Prices with Drifting Equilibrium Rates

Published online by Cambridge University Press:  04 January 2023

Carlo A. Favero Open the ORCID record for Carlo A. Favero [Opens in a new window] ,
Alessandro Melone  and
Andrea Tamoni
Carlo A. Favero*
Affiliation:
Bocconi University Department of Finance, Innocenzo Gasparini Institute for Economic Research (IGIER), and Centre for Economic Policy Research (CEPR)
Alessandro Melone
Affiliation:
The Ohio State University Fisher College of Business amelone.research@gmail.com
Andrea Tamoni
Affiliation:
Rutgers Business School atamoni@business.rutgers.edu
*
carlo.favero@unibocconi.it (corresponding author)
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Abstract

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We study the drift and cyclical components in U.S. Treasury bonds. We find that bond yields are drifting because they reflect the drift in monetary policy rates. Empirically, modeling the monetary policy drift using demographics and productivity trends, plus long-term inflation expectations, leads to cyclical deviations of bond prices from their drift that predict bond returns in- and out-of-sample. These bond cycles can be interpreted as term premia or/and temporary deviations from rational expectations in a behavioral framework. Through the lens of our model, we detect a significant role of the latter in determining the cyclical properties of yields with short maturities.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 59 , Issue 2 , March 2024 , pp. 626 - 651
Creative Commons
Creative Common License - CCCreative Common License - BY
This is an Open Access article, distributed under the terms of the Creative Commons Attribution licence (https://creativecommons.org/licenses/by/4.0), which permits unrestricted re-use, distribution and reproduction, provided the original article is properly cited.
Copyright
© The Author(s), 2023. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

Footnotes

We are grateful to Pierluigi Balduzzi, Hendrik Bessembinder (the editor), John Cochrane, Vito Gala, Kasper Joergensen, Scott Joslin (the referee), Fabio Trojani, Christian Wagner, Josef Zechner, and participants at the LTI/Bank of Italy Workshop 2021, the BFWG Conference 2021 at Queen Mary University of London, the IAAE Annual Conference 2021, the 2021 INQUIRE Residential Seminar, and the 2022 Asset Pricing Workshop for their comments. Alessandro Melone acknowledges the financial support from the Austrian Science Fund (FWF).

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