Forward Guidance, Monetary Policy Uncertainty, and the Term Premium

July 12, 2017
By Brent Bundick, Research and Policy Advisor , A. Lee Smith, Research and Policy Advisor and Trenton Herriford


Research Working PaperForward guidance about future monetary policy can materially affect term premia in bond markets, even without large-scale asset purchases.

We examine the macroeconomic and term-premia implications of monetary policy uncertainty shocks. Using Eurodollar options, we employ the VIX methodology to measure implied volatility about future short-term interest rates at various horizons. We identify monetary policy uncertainty shocks using the unexpected changes in this term structure of implied volatility around monetary policy announcements. Two principal components succinctly characterize these changes around policy announcements, which have the interpretation as shocks to the level and slope of the term structure of implied interest rate volatility. We find that an unexpected decline in the slope of implied volatility lowers term premia in longer-term bond yields and leads to higher economic activity and inflation. Our results suggest that forward guidance about future monetary policy can materially affect bond market term premia, even without large-scale asset purchases.

Download paper, RWP 17-07, July 2017 

Additional Files:  Appendix

JEL Classification: E32; E52

Article Citation

  • Bundick, Brent, Trenton Herriford and A. Lee Smith. “Forward Guidance, Monetary Policy Uncertainty, and the Term Premium,” Federal Reserve Bank of Kansas City working paper no. 17-07, July, available at https://doi.org/10.18651/RWP2017-07

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