Monetary Policy Regimes and The Term Structure of Interest Rates

This paper proposes to investigate whether US monetary policy changed over time by evaluating evidence from the entire yield curve. A regime-switching no-arbitrage term structure model relies on inflation, output and the short interest rate as factors. In a departure from the finance literature, the model is complemented with identifying assumptions that allow the private sector (inflation and output dynamics) to be separated from monetary policy (short interest rate). The model posits regime changes in the volatility of exogenous output and inflation shocks, in the monetary policy rule, and in the volatility of monetary shocks. The monetary policy regimes cannot be identified correctly if the yield curve is ignored during estimation. Counterfactual analysis uses the disentangled regimes in policy and shocks to understand their importance for the great moderation. The low-volatility regime of exogenous shocks during the last two decades plays an important role, while monetary policy contributes by trading off asymmetric responses of output and inflation under different regimes. Bikbov is affiliated with Barclays Capital. Chernov is affiliated with London Business School and CEPR. We would like to thank Andrew Ang, Geert Bekaert, Jean Boivin, Seth Carpenter, Greg Duffee, Marc Giannoni, Robert Hodrick, Mike Jonannes, Don Kim, Jean-Philippe Laforte, Alexei Onatski, Athanasios Orphanides, Tano Santos, Suresh Sundaresan, Neng Wang, Min Wei, Tack Yun, and Hao Zhou for fruitful discussions and participants of Columbias doctoral students workshop, Columbia finance and macro workshops, and the seminars at the Federal Reserve Board of Governors, Kellogg and MIT.