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Switching monetary policy regimes and the nominal term structure

Ferman, Marcelo (2011) Switching monetary policy regimes and the nominal term structure. Financial Markets Group Discussion Papers (678). Financial Markets Group, The London School of Economics and Political Science, London, UK.

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Abstract

In this paper I propose a regime-switching approach to explain why the U.S. nominal yield curve on average has been steeper since the mid-1980s than during the Great Inflation of the 1970s. I show that, once the possibility of regime switches in the short-rate process is incorporated into investors' beliefs, the average slope of the yield curve generally will contain a new component called 'level risk'. Level-risk estimates, based on a Markov-Switching VAR model of the U.S. economy, are then provided. I find that the level risk was large and negative during the Great Inflation, reflecting a possible switch to lower short-rate levels in the future. Since the mid-1980s the level risk has been moderate and positive, reflecting a small but still relevant possibility of a return to the regime of the 1970s. I replicate these results in a Markov-Switching dynamic general equilibrium model, where the monetary policy rule followed by the Fed shifts between an active and a passive regime. The model also explains why in recent decades the U.S. yield curve on average has been steeper than the yield curve in countries that adopted explicit inflation targeting frameworks.

Item Type: Monograph (Discussion Paper)
Official URL: https://www.fmg.ac.uk/
Additional Information: © 2011 The Author
Divisions: Financial Markets Group
Subjects: H Social Sciences > HC Economic History and Conditions
H Social Sciences > HG Finance
JEL classification: E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E42 - Monetary Systems; Standards; Regimes; Government and the Monetary System
E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E43 - Determination of Interest Rates; Term Structure of Interest Rates
E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy
E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy (Targets, Instruments, and Effects)
E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E58 - Central Banks and Their Policies
Date Deposited: 04 Jul 2023 08:12
Last Modified: 14 Sep 2024 04:31
URI: http://eprints.lse.ac.uk/id/eprint/119070

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