Macro Factors and the Term Structure of Interest Rates

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Abstract
This paper presents an essentially affine model of the term structure of interest rates making use of macroeconomic factors and their long-run expectations. The model extends the approach pioneered by Kozicki and Tinsley (2001) by modeling consistently long-run inflation expectations simultaneously with the term structure. Application to the U.S. economy shows the importance of long-run inflation expectations in the modeling of long-term bond yields. The paper also provides a macroeconomic interpretation for the latent factors found in standard finance models of the yield curve: the level factor represents the long-run inflation expectation of agents; the slope factor captures business cycle conditions; and the curvature factor expresses a clear independent monetary policy factor.

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