Bond Risk Premiums and Optimal Monetary Policy

Abstract

The bond yield dynamics implied by a welfare-maximizing monetary policy and its credibility are explored in general equilibrium. Credibility is captured by a regime change from discretion to commitment. The policy determines the optimal output and inflation responses to a source of inflation risk. Bond yields contain compensations for this risk that depend on the policy. Credibility improvements reduce the exposure to inflation risk and bond risk premiums decline. A model calibration implies lower yield spreads, less volatile yields, and reduced deviations from the expectations hypothesis under commitment. The model suggests an explanation for changes in yield dynamics in the U.S. across different policy regimes.

Keywords: Affine Term Structure, General Equilibrium, Time-Varying Term Premiums, Monetary Policy, Discretion vs. Commitment

JEL Classification: D51, E43, E52, G12