Must-Read: Jens H.E. Christensen and Glenn D. Rudebusch: New Evidence for a Lower New Normal in Interest Rates

Must-Read: Mark Thoma sends us to:

Jens H.E. Christensen and Glenn D. Rudebusch: New Evidence for a Lower New Normal in Interest Rates: “Inflation-indexed bond prices include a real term premium… face appreciable liquidity risk… http://www.frbsf.org/economic-research/publications/economic-letter/2017/june/financial-market-evidence-for-lower-natural-interest-rate-r-star/

…To estimate the equilibrium rate of interest from TIPS in the presence of liquidity and real term premiums, we use an arbitrage-free dynamic term structure model of real yields augmented with a liquidity risk factor…. The identification of the liquidity risk factor comes from its unique loading for each individual TIPS. This loading assumes that, over time, an increasing proportion of any bond’s outstanding inventory is locked up…. By observing prices from a cross section of TIPS that have different age characteristics, we can identify the liquidity factor. With estimates of both the liquidity premium and real term premium, we calculate the equilibrium interest rate as the average expected real short rate over a five-year period starting five years ahead. Our finance-based estimate of the natural rate of interest is shown as the green line in Figure 1…

Economic Research New Evidence for a Lower New Normal in Interest Rates

June 21, 2017

AUTHORS:

Brad DeLong
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