Secular Economic Changes and Bond Yields

We build a small-scale representation of an economy in which the short rate, inflation and output exhibit unobserved secular and cyclical components that both drive bond yields. We impose the economic restriction that expected bond returns are purely cyclical so that their variance does not diverge with the returns horizon. Estimates for the US Treasury yield market show that the expectation components in bond yields exhibit similar impulse-response functions across structural shocks but the term premiums do not. The response of the term premium is more cyclical than in a benchmark stationary model. However, this response amplifies the transmission of the output shocks to long-term yields and offsets the transmission of the inflation and short-rate shocks. Our baseline model features time-variations in the loadings of structural shocks that are necessary in order to match the behavior of the inflation and real rate in the data. This baseline attributes the recent decline in output growth, the neutral rate and yields to real output shocks. By contrast, a model with constant loadings attributes most of this recent decline to the short-rate shocks