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The Term Structure of Interest Rates in an Estimated New Keynesian Policy Model

We jointly estimate a New Keynesian policy model with a Gaussian affine no-arbitrage specification of the term structure of interest rates, and assess how important inflation, output and monetary policy shocks are as sources of fluctuations in interest rates and the term premium. We work with observable pricing factors and utilize the computationally convenient normalization of Joslin et al. (2013b). This allows us to estimate the model without needing to restrict the parameters driving the market prices of risk. Using data for the U.S. from 1962:Q1 to 2014:Q2, we find that inflation and the output gap account for around 80% of the unconditional forecast error variance of bond yields at the short and medium end of the term structure, while monetary policy shocks account for around 20%. Bond yields respond to macroeconomic shocks only gradually, peaking after about 4 quarters. This is due to sizable monetary policy inertia estimates in our model. At the peak of the response, inflation shocks increase bond yields by more than one-to-one, and output shocks by less than one-to-one, which is consistent with a Taylor type monetary policy rule. Our term premium estimate is strongly counter-cyclical and can capture salient features of the term structure that constitute a puzzle in the expectations hypothesis.