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Expectations, Bond Yields and Monetary Policy

May 2005
Working Paper
04-023
By  Albert Chun
Through explicitly incorporating analysts' forecasts as observable factors in a dynamic arbitrage-free model of the yield curve, this paper proposes a framework for studying the impact of shifts in market sentiment on interest rates of all maturities. An empirical examination reveals that survey expectations about inflation, output growth and the anticipated path of monetary policy actions contain important information for explaining movements in bond yields. Although perceptions about inflation are largely responsible for movements in long-term interest rates, an explicit slope factor is necessary to adequately capture the dynamics of the yield curve. Macroeconomic forecasts play an important role in explaining time-variation in the market prices of risk, with forecasted GDP growth playing a dominant role. The estimated coefficients from a forward-looking monetary policy rule support the assertion that the central bank preemptively reacts to inflationary expectations while suggesting patience in accommodating real output growth expectations. Models of this type may provide traders and policymakers with a new set of tools for formally assessing the reaction of bond yields to shifts in market expectations due to the arrival of news or central bank statements and announcements.