A Structural Decomposition of the US Yield Curve

Abstract

We estimate a medium-scale macro-finance DSGE model of the term structure. By expanding the macro part of macro-finance models, historical fluctuations in US bond yields turn out to be largely consistent with the rational expectations hypothesis. This stands in contrast to extant macro-finance models and suggests that their - small-scale or non-structural - perspective on the macroeconomy mutes expectations, thereby underestimating the expectations hypothesis' potential. Out-of-sample forecasts are competitive with more flexible models of the yield curve. We interpret various episodes through the lens of the model. The inflation hike in the mid-seventies was predominantly the result of markup shocks to wages and prices, while monetary policy's commitment to fighting inflation was largely credible. Although the Fed succeeded in bringing down inflation in the early eighties, it had less success in lowering inflation expectations. The model suggests the mid 2000 non-response of long rates to monetary policy is a to a large extent the logical consequence of the Fed's response to demand-type shocks hitting the economy. Finally, the paper investigates which structural shocks cause the yield curve to contain information about future growth.