Term Premia: Endogenous Constraints on Monetary Policy

By Sharon Kozicki and P.A. Tinsley
December 2002 
RWP 02-07
Research Division 
Federal Reserve Bank of Kansas City 

Abstract

       Monetary policy evaluation using structural macro models suggests that historical monetary policy responds less aggressively to inflation and the output gap than would an optimal policy rule. However, these results are obtained using models with constant term premia. This paper shows how term premia may depend on the policy rule specification and policy rate uncertainty. A more aggressive policy rule involves an economically important increase in term premia. Consequently, conclusions about the specification of optimal monetary policy rules based on counterfactual simulations of models that exclude term premia effects may not be valid.

Keywords: optimal policy; term structure of interest rates; monetary policy transmission

JEL Codes: E4, E5, G1

Sharon Kozicki is an assistant vice president and economist at the Federal Reserve Bank of Kansas City. P.A. Tinsley is a lecturer on the Faculty of Economics and Politics at the University of Cambridge, Cambridge, England. The authors are grateful for comments from sessions participants at the 2002 Annual meetings of the American Economic Association and the 2002 Conference of the Society for Computational Economics and for research assistance from Matthew Cardillo. The views expressed in this paper are those of the authors and do not necessarily represent the views of the Federal Reserve Bank of Kansas City or the Federal Reserve System.

Kozicki e-mail:  sharon.kozicki@kc.frb.org
Tinsley e-mail:  ptinsley@econ.cam.ac.uk