Switching Monetary Policy Regimes and the Nominal Term Structure

Abstract

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