Economic Policy Uncertainty and the Yield Curve

Abstract

We study the impact of economic policy uncertainty on the term structure of nominal interest rates. We develop a general equilibrium model, in which the real side of the economy is driven by government policy uncertainty and the central bank sets money supply endogenously following a Taylor rule. We analyze the impact of government and monetary policy uncertainty on nominal yields, short rates, bond risk premia, and the term structure of bond yield volatility. Our affine yield curve model is able to capture both the shape of the interest rate term structure as well as the hump-shape of bond yield volatilities. Our empirical analysis shows that higher government policy uncertainty leads to a decline in yields and an increase in bond yield volatility, whereas monetary policy uncertainty has no significant contemporaneous effect on yields nor volatilities. However, it is an important predictor for bond risk premia.