The estimated yield-curve model explains the “snake-shaped” term structure of volatility in yields, based on
interest-rate smoothing and policy inertia. Macroeconomic surprises are only
temporary components of macro variables. This means that the impact of these
surprises on longer yields needs to occur over time through a “policy-inertia factor.” The model
improves the fit of bond prices over a 3-latent-factor model, especially for
short maturities. A policy rule is identified from weekly yield data and is
found to provide a good description of the target. In fact, model-based
forecasts of future target rates outperform several benchmarks.
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