By Michael D. Bauer and Glenn D. Rudebusch
“Long-term U.S. government bond yields have trended down for more than two decades, but identifying the source of this decline is difficult. A new methodology suggests that reductions in long-run expectations of inflation and inflation-adjusted interest rates have played a significant role in the secular decline in yields. In contrast, standard statistical finance methods appear to overemphasize the effects of lower risk premiums and reduced uncertainty about future inflation.
Identifying the sources of this long-run decline in interest rates is of great interest to monetary policymakers, bond investors, and other financial market participants. But it is quite difficult to do. Standard statistical finance methods as employed, for example, in Wright (2011), suggest that the reduction largely reflected a decline in inflation uncertainty and that any decline in long-run expectations about inflation rates or real, that is, inflation-adjusted, interest rates played a small role. However, these methods suffer from statistical bias and can give misleading results. In recent research, we correct for this bias and reexamine the variation in long-term interest rates (Bauer, Rudebusch, and Wu 2013). ThisEconomic Letter summarizes our results, which differ from the standard ones by suggesting that falling long-run expectations of inflation and real yields were an important part of the secular decline in long-term yields.