Mikhail Chernov, London Business School and CEPR. CREST. February 2009 ... What are the economic forces driving regime s
Monetary Policy Regimes and The Term Structure of Interest Rates Ruslan Bikbov, Barclays Capital Mikhail Chernov, London Business School and CEPR
CREST February 2009
Question • Did US monetary policy change over time? – Monetary policy=Rule Example of a rule: Change in the monetary policy=change in
• Is the yield curve helpful in addressing this issue?
2
Motivation: Macro Perspective • The debate over monetary policy changes in the US – Monetary policy changed: Clarida, Gali and Gertler (2000) – Monetary policy did not change: Sims and Zha (2005)
• Use term structure data to identify the changes in monetary policy?
– Yields are forward-looking – Yields must reflect expectations about the future monetary policy
3
Rates Contain Information about Future Regimes • Simple rule
with two regimes:
and
• Expectations involve information about regimes
4
Motivation: Finance Perspective • Existing no-arbitrage regime-switching term structure models are reduced-form
– Bansal and Zhou (2002) – Dai, Singleton and Yang (2006) – Ang, Bekaert and Wei (2008)
• What are the economic forces driving regime switches? – Monetary policy changes? – Changes in the volatility of exogenous shocks?
5
Approach • We specify and estimate a no-arbitrage regime-switching term structure model with observable macro variables.
• Key innovations of this paper – The model explicitly separates Regime-switching Fed’s behavior (monetary policy regimes) Private sector dynamics
– Solve a rational expectations model with regime switches – New and accurate approximate bond pricing method
6
Term Structure Is Informative About Regimes 1
Estimated Probability of the Policy Regime without Term Structure
0.8 0.6 0.4 0.2 0 1970
1
1975
1980
1985
1990
1995
2000
2005
Estimated Probability of the Policy Regime with Term Structure
0.8 0.6 0.4 0.2 0 1970
1975
1980
1985
1990
1995
2000
2005
7
Outline 1. 2. 3. 4. 5. 6.
Model Empirical Methodology Model Properties Importance of Term Structure Model Implications Conclusion
8
Outline 1. 2. 3. 4. 5. 6.
Model Empirical Methodology Model Properties Importance of Term Structure Model Implications Conclusion
9
State Dynamics • State vector • State equations
systematic policy
policy shock
• Regime variables - Systematic monetary policy - Volatility of monetary policy shock (discretion) - Volatilities of exogenous shocks 10
• Each regime variable follows a Markov chain with constant transition probabilities
11
Rational Expectations Solution • Assumptions: – Agents know in which regime they are in – Exogenous regime switches (constant transition probabilities)
• Rational expectations solution
12
Need for Identification Assumptions • State vector • Generic form of dynamics (no regimes) • Rational expectations solution: • Relations among the parameters:
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Prices of Risk • Pricing kernel • Risk premium • “Preferences” (Duffee 2002) • Bond prices
14
Outline 1. 2. 3. 4. 5. 6.
Model Empirical Methodology Model Properties Importance of Term Structure Model Implications Conclusion
15
Empirical Approach • 1970:Q1-2004:Q4, quarterly frequency • Macro variables – Inflation: Implicit Price Deflator – Output gap: Linearly detrended log of real GDP
• 4 Fama-Bliss zero yields with maturities 3 months, 2 years, 5 years and 10 years
• Estimation – Maximum likelihood – Output, inflation and 3 month yield observed exactly 16
Outline 1. 2. 3. 4. 5. 6.
Model Empirical Methodology Model Properties Importance of Term Structure Model Implications Conclusion
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Parameter Estimates
18
Parameter Estimates
19
Parameter Estimates
20
Parameter Estimates
21
Parameter Estimates
22
Regimes e
1
Probability of High Volatility Regime st=1
0.5
0 1970
1975
1980
1985
1990
1995
Probability of Active Policy Regime
1
2000
2005
2000
2005
2000
2005
m st=1
0.5
0 1970
1975
1980
1985
1990
1995
Probability of Discretionary Regime
1
d st=1
0.5
0 1970
1975
1980
1985
1990
1995
23
Goodness of Fit • Pricing errors
• Unconditional Moment Tests – Mean, variance, skewness, kurtosis and autocorrelations – All moments are matched except for the kurtosis of the curvature 24
Outline 1. 2. 3. 4. 5. 6.
Model Empirical Methodology Model Properties Importance of Term Structure Model Implications Conclusion
25
Is Short Rate Informative About Regimes?
• Short Rate (SR) Model
is estimated without term structure data (using short interest rate only)
• The full model is referred to as the Term Structure (TS) Model.
26
Parameter Estimates. Model SR.
27
Estimated Regimes. Model SR. e
1
Probability of High Volatility Regime st=1. Model TS.
0.8 0.6 0.4 0.2 0 1970
1975
1980
1985
1990
1995
2000
2005
e
1
Probability of High Volatility Regime st=1. Model SR.
0.8 0.6 0.4 0.2 0 1970
1975
1980
1985
1990
1995
2000
2005
28
Policy Regimes Are Better Identified with TSM Probability of Active Regime sm=1. Model TSM. 1 0.8 0.6 0.4 0.2 0 1970
1975
1980
1985
1990
1995
2000
2005
2000
2005
Probability of Active Regime sm=1. Model SRM. 1 0.8 0.6 0.4 0.2 0 1970
1975
1980
1985
1990
1995
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Term Structure Matters • Simulate 1000 paths from TS • Estimate both TS and SR • Compute
for both
datasets
• Distribution of
:
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Outline 1. 2. 3. 4. 5. 6.
Model Empirical Methodology Model Properties Importance of Term Structure Model Implications Conclusion
31
Causes of “Great Moderation”
• Lower volatility of exogenous shocks helped reduce volatility
• What is the role of monetary policy? 32
Exogenous shocks/Counterfactual analysis
• Indeed, low volatility of shocks contributed to the decline •
of volatilities of output and inflation Monetary policy has minimal impact on the volatilities
33
Trade-Off Between Output and Inflation Output Shock 1
Ou tpu t A ctive MP Pas s ive MP
0.8
Inflatio n Shock
0
Ou tpu t
-0.02 -0.04
0.6
-0.06
0.4 -0.08
0.2
-0.1
0 -0.2
-0.12
-0.4
-0.14 5
10
15
20
Outpu t Shock
0.6
25
30
35
40
Inflatio n
5
0.6
0.5
10
15
20
25
Inflatio n Shock
30
35
40
Inflatio n
0.5
0.4
0.4
0.3
0.3
0.2 0.2
0.1
0.1
0
0
-0.1 -0.2
5
10
15
20
25
30
35
40
-0.1
5
10
15
20
25
30
35
40
34
Counterfactual Time Series
Counterfactual Time Series
• Active/Discretionary regimes appears to be preferred for •
inflation/output trade-off However…
Rates Volatility Is Greater in Active Regime
The Great Moderation Summary
• Inflation is the lowest in the data, not in a specific regime • Output is higher in active regimes, but so is long rate; •
output and yields are more volatile It appears that the overall balance achieved in sample was pretty good
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Outline 1. 2. 3. 4. 5. 6.
Model Empirical Methodology Model Properties Importance of Term Structure Model Implications Conclusion
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Conclusion • Long term rates help identify monetary policy regimes • At least two systematic monetary policy regimes occurred: active and passive
• Monetary policy was important for “great moderation”
