The term structure of interest rates and monetary policy

This dissertation aims to contribute to our understanding of the dynamics of interest rates, monetary policy and economic activity. It consists of three chapters.;The first chapter develops a theoretical framework to analyze how changes in the credibility of monetary policy affect the dynamics of the term structure of interest rates. A robust empirical fact about U.S. nominal interest rates is that they exhibit time-varying risk premia. In the last 20 years, the dynamics of these premia have changed. This chapter provides a monetary-policy explanation for this change. Monetary policy in the United States has achieved greater credibility and, as a result, market participants require less compensation for holding financial assets exposed to inflation risk. This explanation is substantiated using a general equilibrium model with nominal rigidities and habit formation in preferences. Two monetary policy regimes are analyzed: discretion and commitment. The model implies that the inflation risk premia are always lower under commitment and, thus, expected excess returns on bonds are lower and may become negative. The real effects of monetary policy in the model have an important asset-pricing implication: if the elasticity of intertemporal substitution of consumption is lower (greater) than the elasticity of substitution across goods, the inflation risk premium is negative (positive). The model is calibrated to the U.S. economy and is found to be consistent with the recent facts on interest rate behavior and the greater macroeconomic stability observed during the period.;The second chapter studies the economic content of the term structure and how this content can be useful to conduct monetary policy. Interest rates are a rich source of information and thus can be a powerful tool for policy making. However, this information is difficult to extract given its dependence on the actual policy regime and the existence of time-varying term premia. This chapter analyzes the economic content of interest rates when term premia vary over time and monetary policy is optimal. The analysis is complemented with a potentially welfare-improving application for policy making: the formulation of optimal policy rules based on term-structure information. The analysis is conducted for policies with high or low weights on inflation stabilization. It shows that a high inflation weight increases the compensation for real risks in the term structure. As a result, forward rates are less informative about expected future monetary policy, and the term spreads and short-term rate predict better real economic activity and inflation, respectively. In addition, the optimal responses in an interest-rate rule to the lagged short-term rate and term spreads decline.;The third chapter is based on joint work with Michael Gallmeyer, Burton Hollifield and Stanley Zin. It shows how a model that includes a simple monetary policy rule can help us explain the significant volatility observed in long-term interest rates. The model has two important characteristics: (i) inflation is endogenously determined by an interest-rate policy rule and (ii) non-trivial term-premium dynamics are generated by stochastic habit formation in preferences. The model is compared to a similar one with exogenous inflation. The two models capture the average level and shape of the yield curve, the volatility of the short-term interest rate and selected descriptive statistics of consumption growth and inflation. However, the exogenous-inflation model is not able to generate the observed volatility of long-term rates. The endogenous-inflation model with a countercyclical price of consumption growth risk, highly persistent policy shocks and negative correlation between consumption growth and inflation captures long-term rate volatility. Its success relies on an equilibrium inflation process that depends on highly autocorrelated policy shocks. The endogenous-inflation model is used to analyze the effects on the yield curve of policy rules with different responses to economic conditions. It is found that a policy rule with a stronger reaction to inflation explains recent developments in the dynamics of interest rates and inflation.