Essays on the dynamic interaction of expectations, monetary policy and the term structure of interest rates

This dissertation explores the link between market expectations, monetary policy and the term structure of interest rates. Firstly, it introduces a data set of individual forecasters known as the Blue Chip Financial Forecasts. This data set contains analysts' expectations about interest rates and the macroeconomic variables that influence them - inflation and real output growth. I extract individual time-series of the forecasts for every participant in the survey from 1993 to 2006. Secondly, I evaluate the forecasting performance of the individual participants in the Blue Chip Financial Forecasts. By running a horse race between a subset of the individual survey forecasters and a set of purely econometric models, this study examines the ability of different forecasting models to predict interest rates and the macroeconomic variables that influence them. Empirical analysis reveals that fed funds futures prices provide the best forecast of the fed funds rate at very short horizons, Bear Stearns' model is competitive at short horizon forecasts of short maturity interest rates, while US Trust is dominant at forecasting short rates at longer horizons, econometric methods dominate forecasting long maturity yields, and individual survey forecasters, including the mean forecaster, do well at forecasting inflation. I find that the Qrinkage family of forecasting models is very competitive across differing maturities and forecast horizons. Thirdly, having established that the surveys contain valuation information, I incorporate the forecasts as observable factors in a forward-looking dynamic term structure model. The short end of the yield curve is pinned down via a forward-looking monetary policy reaction function, and the behavior of all other yields are restricted via cross-sectional and time-series restrictions so as to preclude the presence of arbitrage opportunities. I estimate two classes of models. The first class of models are driven primarily by the forecasted fed funds rate and the forecasted yield spread. The second class of models allows the macroeconomic information in expected inflation and expected real output growth the first opportunity to explain movements in bond yields. An empirical examination reveals that survey expectations about inflation, output growth and the anticipated path of monetary policy actions contain important information for explaining the dynamics of the yield curve. Consistent with economic intuition, I find that expected inflation has a level effect on all yields, while expected GDP growth and the anticipated monetary policy factor shift the slope of the yield curve. I find that macroeconomic forecasts play an important role in explaining time-variation in the market prices of risk, with forecasted GDP growth playing a dominant role. Impulse response analysis of the short rate under the risk adjusted pricing measure explains the strong response of long yields to transitory shocks in the underlying factors. I also find that the estimated coefficients from a forward-looking monetary policy rule support the assertion that the central bank preemptively reacts to inflationary expectations while suggesting patience in accommodating real output growth expectations. Models of this type may provide traders and policymakers with a new set of tools for formally assessing the reaction of bond yields to shifts in market expectations due to the arrival of news or central bank statements and announcements.