The term structure of interest rates in a noisy information model

Abstract

We study the term structure of interest rates in an endowment economy with noisy information and CRRA preferences. Exogenous prices and consumption consist of both temporary and permanent components, but the household observes only their aggregate values. We show that on average the term spread in this environment is positive and on a scale close to what we observe in the data, a fact that many existing macroeconomic models struggle to reproduce without very large coefficients of relative risk aversion. In our partial-information framework, uncertainty about the decomposition of the endowment and prices into their temporary and permanent components combined with a negative correlation in consumption growth explains why the slope of the yield curve is positive on average. We estimate our model using Bayesian methods and US data from 1961–2007 and find that the average interest rate spread is 0.85 %, compared with 0.98 % in the data. Further, we estimate a coefficient of relative risk aversion of only 4.86. Noisy information accounts for 44 % of the scale of the term premium, with the remainder principally explained by real activity and nominal factors playing only a small role.