How Important Are Inflation Expectations for the Nominal Yield Curve?

Abstract

Macrofinance term structure models rely too heavily on the volatility of expected inflation news as a source for variations in nominal bond yield shocks. We develop and estimate a model featuring inflation nonneutrality and preference shocks. The stochastic volatility of inflation and consumption govern bond risk premiums movements, whereas preference shocks generate fluctuations in real rates. The model accounts for key bond market features without resorting to an overly dominating expected inflation channel. The estimation shows that preference shocks are strongly negatively correlated with market distress factors and that real rate news is the dominant driver of nominal yield shocks.

Yield Curve and the Business Cycle in Conventional Times

“…Observe also that x u Τ and v u increase in absolute value with the persistence of the respective shocks, summarized by the eigenvalues of A and the size of θ . 32,33…”

“…Predecessors to the above models either derive the pricing kernel from preferences but take the inflation-output (consumption) process as given [5] [6] [10] [30], or derive the processes for output and inflation from a structural model but take the pricing kernel from an affine term structure model [31] [32]. Recent examples of the former approach are [7] and [33]. [13] and [34] solve for inflation, given a process for output; [35] do the opposite.…”

Real Term Premia in Consumption-Based Models

“…Rudebusch and Swanson (2012) used a similar model within a DSGE framework, which has real and nominal long-term risks, and they show that positive nominal term premia are generated; nevertheless real term premia are again negative in this model. Gomez-Cram and Yaron (2021) also used a model following Bansal and Yaron (2004), but they focused on explaining nominal term premia, using an inflation channel, while claiming that the apparent under-performance of their model with respect to real term premia should be expected due to liquidity premia in the TIPS market.…”

Fundamental sources of risk and the decline of carry trade returns

“…More recent papers propose that agents become more patient as they become richer and assume that the discount factor depends negatively on the flow of consumption or the stock of wealth (Becker and Mulligan, 1997;Das, 2003;Kam, 2005;Kam and Mohsin, 2006), and the stock of capital (Stern, 2006;Erol et al, 2011). On the other hand, Chen and Yang (2019) associates time-varying discount factor with agent's longevity 13 , Creal and Wu (2020) assume that the rate of time preference is stochastic but it also depends on macroeconomic variables (aggregate consumption and inflation) and other authors consider a pure stochastic discount factor (Dutta and Michel, 1998;Eggertsson, 2011;Maurer, 2012;Nakata and Tanaka, 2020;Guerrieri et al, 2020;Gomez-Cram and Yaron, 2021;Kliem and Meyer-Gohde, 2022). 14 In contrast to the studies that maintain the assumption of consistent preferences, another body of literature challenges this traditional view by suggesting that discount rates are not constant over time.…”

“…However, this also introduces the potential for increased sensitivity to shocks, which in turn may contribute to greater macroeconomic volatility and business cycle fluctuations. Lastly, the authors note that their model reflects the experiences of many emerging countries in Asia, Latin America, and Europe.12 There are several papers that consider shocks to preferences or "taste shocks" in the asset pricing literature(Campbell, 1986;Stockman and Tesar, 1995;Pavlova and Rigobon, 2007;Maurer, 2012;Gabaix and Maggiori, 2015;Albuquerque et al, 2016;Chen and Yang, 2019;Gomez-Cram and Yaron, 2021) Albuquerque et al (2016). call the risk associated with preference shocks as "Valuation risk".…”