Evaluating the interplay of term premia, monetary policy, and the economy in the euro area

Abstract

This paper investigates the interplay of term premia, monetary policy, and the economy in the euro zone. For this purpose I use a no-arbitrage macro-finance model of the term structure of government bond yields as in Ireland (2015), where yields are modeled as linear-affine functions of the state vector. Movements in term premia are captured by an unobservable risk variable. Restric- tions on the dynamic of the state equation are entailed in order to identify the structural model. The model is estimated using Bayesian estimation techniques. The results highlight a rich dynamic between term premia, monetary policy, and the economy. In line with the "practitioners view" I find that an exogenous rise in pre- mia dampens economic activity. Moreover, during the sample period, the ECB lowered the nominal short-term interest rate in response to a rise in term premia.