Discussion Paper Series 2010-E-24

The Role of Monetary Policy Uncertainty in the Term Structure of Interest Rates

Junko Koeda, Ryo Kato

We examine the effect of uncertainty arising from policy-shock volatility on yield-curve dynamics. In contrast to the assumption of many macro-finance models, policy-shock processes appear to be time varying and persistent. We allow for this heteroskedasticity by constructing a no-arbitrage GARCH affine term structure model, in which policy-shock volatility is defined as the conditional volatility of the error term in a Taylor rule. We find that an increase in monetary policy uncertainty raises the medium- and longer-term spreads in a model that incorporates macroeconomic dynamics.

Keywords: GARCH; Estimation; Term Structure of Interest Rates; Financial Markets and the Macro-economy; Monetary Policy

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

Copyright © 2010 Bank of Japan All Rights Reserved.

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