Abstract

I present a framework for modeling part of the dynamics of the term structure. The framework can be used to link the term structure to observed variables such as inflation and output. Its partial nature allows us to dispense with yield-based factors (e.g., latent factors) while retaining restrictions associated with no-arbitrage. I apply the model to the joint dynamics of inflation and the term structure. As other research has noted, both short-term and long-term bond yields adjust gradually to a change in inflation. I find that the dynamics of the price of interest rate risk needed to fit this pattern from 1983 through 2003 are implausible. An alternative interpretation is that investors were systematically surprised by the slow adjustment of short-term yields to inflation.

Citations