DeFiPP Research Seminar-Jesus Vazquez Perez (University of the Basque Country)

Uncertainty, misaligned expectations, and bond term premium measures

Abstract:

This paper shows that inflation expectations and those embedded in short-term interest rate expectations as reported in the Survey of Professional Forecasters show evidence of misaligned expectations. This misalignment seems to have been substantial in recent times, featuring a low correlation between inflation and the policy rate (i.e. the Gibson paradox). This empirical evidence motivates an alternative explanation, based on uncertainty rather than risk, of the bond term premium measures found in the literature. This paper estimates an expectational term premium driven by misaligned short-term interest rate expectations from a medium-scale DSGE model, which introduces uncertainty by assuming adaptive learning (AL) with discretional beliefs . The estimated 10-year expectational term premium shares important features with the corresponding term premium measures obtained in the literature using no-arbitrage affine term structure models. Thus, the expectational term premium is sizable, highly persistent, and mildly countercyclical. More important, this expectational AL term premium is highly correlated with term premium measures obtained from no-arbitrage affine models in the most recent period studied. In short, the estimation results suggest that model uncertainty provides an important channel for explaining the bond premium measures lately by introducing a potential misalignment of short-term interest expectations with inflation expectations.

Contact : Romain Houssa - Romain.Houssa@unamur.be
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