Interest Rates Under Falling Stars

Theory predicts that the equilibrium real interest rate, r*t, and the perceived trend in inflation, ð*t, are key determinants of the term structure of interest rates. However, term structure analyses generally assume that these endpoints are constant. Instead, we show that allowing for time variation in both r*t and ð*t is crucial for understanding the empirical dynamics of U.S. Treasury yields and risk pricing. Our evidence reveals that accounting for fluctuations in both r*t and ð*t substantially increases the accuracy of long-range interest rate forecasts, helps predict excess bond returns, improves estimates of the term premium in long-term interest rates, and captures a substantial share of interest rate variability at low frequencies.