developments in macro-finance yield curve modelling...developments in macro-finance yield curve...

Developments in Macro-Finance YieldCurve Modelling

Changes in the shape of the yield curve have traditionally been one ofthe key macroeconomic indicators of a likely change in economic outlook.However, the recent financial crises have created a challenge to the manage-ment of monetary policy, demanding a revision in the way that policymakersmodel expected changes in the economy. This volume brings togethercentral bank economists and leading academic monetary economists topropose new methods for modelling the behaviour of interest rates. Topicscovered include: the analysis and extraction of expectations of future mon-etary policy and inflation; the analysis of the short-term dynamics of moneymarket interest rates; the reliability of existing models in periods of extrememarket volatility and how to adjust them accordingly; the role of govern-ment debt and deficits in affecting sovereign bond yields and spreads. Thisbook will interest financial researchers and practitioners as well as academicand central bank economists.

J A G J I T S . C H A D H A is Professor of Economics at the University of Kentand is on the Advisory Board of the Centre of International Macroeco-nomics and Finance at the University of Cambridge. His research involvesincorporating financial factors in macroeconomic models and he has actedas an adviser to many central banks throughout the world.

A L A I N C . J . D U R R É is Principal Economist in the Financial ResearchDivision of the Directorate General Research of the European Central Bankand is Associate Professor of Finance at IÉSEG-School of Management atLille Catholic University. He has published various papers on monetary andfinancial economics in many leading academic journals and he has acted asMonetary Policy Adviser for the International Monetary Fund.

M I C H A E L A. S . J OY C E is an Adviser in the Macro Financial AnalysisDivision of the Bank of England and has over twenty years’ experienceworking at the Bank of England in various economics roles. His recentresearch has focused on modelling the term structure of interest rates andon analysing the effects of the UK’s quantitative easing policy.

L U C I O S A R N O is a Professor of Finance, Deputy Dean and Head of theFinance Faculty at Cass Business School, City University London. Hismain research interests are in international finance, and he is a leadingexpert on exchange rates, a subject on which he writes prolifically andon which he is routinely called for advice by governments, internationalorganisations, and financial companies around the world.

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Cambridge University Press978-1-107-04455-5 - Developments in Macro-Finance Yield Curve ModellingEdited by Jagjit S. Chadha, Alain C. J. Durré, Michael A. S. Joyce and Lucio SarnoFrontmatterMore information

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Macroeconomic Policy Making

Series editors

Professor JAGJIT S. CHADHA University of Kent, CanterburyProfessor SEAN HOLLY University of Cambridge

The 2007–2010 financial crisis has asked some very hard questions of modernmacroeconomics. The consensus that grew up during ‘the Great Moderation’has proved to be an incomplete explanation for how to conduct monetary policyin the face of financial shocks. This series brings together leading macroeco-nomic researchers and central bank economists to analyse the tools and methodsnecessary to meet the challenges of the post- financial crisis world.

Published titles:Chadha and Holly Interest Rates, Prices and Liquidity: Lessons from the FinancialCrisisCoffman, Leonard and Neal Questioning Credible Commitment: Perspectives on theRise of Financial Capitalism




Developments inMacro-Finance Yield CurveModelling

Edited by

Jagjit S. ChadhaAlain C. J. DurréMichael A. S. JoyceLucio Sarno




University Printing House, Cambridge CB2 8BS, United Kingdom

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Contents

List of figures page viiiList of tables xiiiList of contributors xviForeword xixPreface xxiii

1 Editors’ introductory chapter and overview 1J. S . C H A D H A , A . C . J . D U R R É ,M . A . S . J OY C E A N D L . S A R N O

Part I Keynote addresses

2 Is the long-term interest rate a policy victim, a policyvariable or a policy lodestar? 19P H I L I P T U R N E R

3 Sovereign debt and monetary policy in the euro area 56A L A I N C . J. D U R R É A N D F R A N K S M E T S

4 The Federal Reserve’s response to the financial crisis:what it did and what it should have done 90D A N I E L L . T H O R N T O N

5 Tail risks and contract design from a financial stabilityperspective 121PAT R I K E D S PA R R A N D PA U L F I S H E R

Part II New techniques

6 Compound autoregressive processes and defaultablebond pricing 141A L A I N M O N F O R T A N D J E A N -PA U L R E N N E

v




vi Contents

7 Yield curve dimensionality when short rates are nearthe zero lower bound 169J A M E S M . S T E E L E Y

8 The intelligible factor model:international comparison and stylized facts 200Y VA N L E N G W I L E R A N D C A R L O S L E N Z

9 Estimating the policy rule from money market rateswhen target rate changes are lumpy 216J E A N -S É B A S T I E N F O N TA I N E

10 Developing a practical yield curve model: an odyssey 251M . A . H . D E M P S T E R , J A C K E VA N SA N D E L E N A M E D O VA

Part III Policy

11 The repo and federal funds markets before, during,and emerging from the financial crisis 293M O R T E N B E C H, E L I Z A B E T H K L E E A N DV I K T O R S S T E B U N O V S

12 Taylor rule uncertainty: believe it or not 326A N D R E A B U R A S C H I , A N D R E A C A R N E L L IA N D PA U L W H E L A N

Part IV Estimating inflation risk

13 Inflation compensation and inflation risk premia inthe euro area term structure of interest rates 361J U A N A N G E L G A R C Í A A N D T H O M A S

W E R N E R

14 The predictive content of the yield curvefor inflation 390H A N S D E WA C H T E R , L E O N A R D O I A N I AA N D M A R C O LY R I O

15 Inflation risk premium and the term structure ofmacroeconomic announcements in the euro area andthe United States 412M A R C E L L O P E R I C O L I




Contents vii

Part V Default risk

16 A term structure model for defaultable Europeansovereign bonds 457P R I S C I L L A B U R I T Y, M A R C E L O M E D E I R O SA N D L U C I A N O V E R E D A

17 Some considerations on debtand interest rates 504L U I G I M A R AT T I N , PA O L O PA E S A N IA N D S I M O N E S A L O T T I

Index 534




Figures

2.1 Real long-term Treasury yields page 202.2 Outstanding debt of domestic US non-financial

borrowers 232.3 Lightening the interest expense of heavy debt 242.4 Net interest payments and household debt service ratio 252.5 Incentives for interest rate carry trades 262.6 Propensity to save in developing Asia 282.7 Issuance of AAA-rated securities 302.8 Issuance of AAA-rated securities: fixed-rate 312.9 Maturity of US government bonds 463.1 Money market spreads at various maturities in the

euro area 663.2 Evolution of public finances in industrialised

countries from 2005 (% of GDP) 663.3 General government deficit within the euro area

(% of GDP) 673.4 General government gross debt within the euro area

(% of GDP) 683.5 10-year government bond spreads against German

Bunds 693.6 Composite Index of Systemic Stress (CISS) indicator 703.7 Contagion from government to banking sector 713.8 Covered bond spreads against 5-year swap rate

(daily, basis points) 733.9 Outstanding open market operations of the Eurosystem 753.10 The euro area deposit (unsecured) market: yield

curve of spreads against OIS 763.11 The euro area repo (secured) market: yield curve of

spreads against OIS 763.12 Tensions on sovereign debt and money market: link

between Greece’s CDS premium (5-year) and the3-month EURIBOR-OIS spreads 77

viii




List of figures ix

3.13 CDS premium of Portugal and Ireland and3-month EURIBOR-OIS spreads 78

3.14 Composite bank lending rate for non-financialcorporations (% per annum) 79

3.15 Composite bank lending rate for private households(% per annum) 80

4.1 The 1-month Libor-OIS and CD-Treasury spreads 974.2 The 6-month Libor-OIS and AAA

industrial-Treasury spreads 974.3 The monetary base, the federal funds rate, and the

funds rate target 984.4 The federal funds rate, funds rate target, and

1-month OIS rate 994.5 The spread between 10-year AAA industrial and

Treasuries 1024.6 The 10-year Treasury yield 1044.7 The federal funds rate target 1086.1 Examples of Car processes 1546.2 Modelling the term-structure of sovereign spreads

(Spain vs Germany): model fit and credit risk premia 1626.3 Historical vs risk-neutral probabilities of default 1647.1 Average spot and forward yield curves 1707.2 Level, slope and curvature components of Nelson

and Siegel spot and forward curves 1747.3 The forward curve and gilt purchases of similar

maturities 1877.4 The forward curve and gilt purchases across a range

of maturities 1887.5 Influence of the first principal component on the

yield curve 1937.6 Influence of the second principal component on the

yield curve 1947.7 Influence of the third principal component on the

yield curve 1957.8 Influence of the fourth principal component on the

yield curve 1968.1 Long, short, and curvature loadings for the three

countries 2028.2 Impulse-response functions 2068.3 Term structure of interest rate variance and the

shares that it attributes to innovations into the threefactors 207




x List of figures

8.4 Long, short, and curvature factors for the threecountries 209

8.5 Impulse-response functions with 95% confidencebands for the three data sets 214

9.1 The target federal funds rate and the 6-monthahead federal funds futures rates 220

9.2 The spread between the effective overnight Fedfunds rate and the Fed’s target rate 230

9.3 Estimate of the parameter controlling the price ofmacro risk, λz,t, from the Gaussian model and thediscrete model 239

9.4 Correlations of the macro factor and the ADS index 2409.5 The filtered values of the macro factor and the ADS

index 2419.6 The filtered values of the macro factor in 2007–2011 2419.7 Evolution of the macro factor between November

2008 and December 2011 24210.1 BDFS model in-sample implied yield curves 26410.2 Vasicek model in-sample implied yield curves 26710.3 JSZ/HW model in-sample local optimum implied

yield curves 27610.4 JSZ/HW model long-term implied yield curves in-

and out-of-sample 27810.5 JSZ/HW 10-year rate distribution out-of-sample

evolution quantiles from 30 December 2011 28110.6 Black model non-negative 10-year rate distribution

out-of-sample evolution quantiles from 30December 2011 285

10.7 Black model long-term non-negative yield curves 28611.1 Spread between federal funds and Treasury GC repo 29511.2 Primary dealers repurchase agreement volume 29811.3 Federal funds market volume 30011.4 Net Treasury securities issuance and Treasury

General Account balance 30712.1 Interest rate smoothing 34012.2 Inflation response 34112.3 Output response 34212.4 Cross-sectional R̄2 34312.5 Disagreement about the Taylor rule 34412.6 Non-parametric analysis 34512.7 Disagreement about the parameters of the Taylor rule 34712.8 Ambiguity about the parameters of the Taylor rule 348




List of figures xi

12.9 Disagreement vs ambiguity: inflation loading 34912.10 Disagreement vs ambiguity: output gap loading 35012.11 Monetary policy uncertainty 35112.12 Term structure of uncertainty 35213.1 BEIR ending in one year 37013.2 One-year forward BEIR ending in two years 37113.3 One-year forward BEIR ending in five years 37113.4 Term structure model measurement equations:

fitted and observed values 37213.5 Measurement errors for nominal and real yields:

observed over fitted values 37513.6 Estimated and model-free measures of long-term

inflation risk premium 38214.1 10-year yield spread: fitted value and expectations

and term premium components 40014.2 Historical decomposition: conundrum period 40214.3 Historical decomposition: current financial crisis 40315.1 United States: breakeven inflation rates, expected

inflation rates and risk premia 43415.2 Euro area: breakeven inflation rates, expected

inflation rates and risk premia 43515.3 Constrained and unconstrained factor loadings 43815.4 Impulse response function of forward inflation rates 44015.5 Cross-correlogram between macroeconomic and

monetary news 44015.6 Impulse response functions 44416.1 1-year sovereign bond yield spread (% pa) –

selected countries 46516.2 Central government budget deficit 46616.3 Deficit vs 1-year bond yield spreads – 4 quarters

moving average 46716.4 Moody’s high yield and 10-year bond yields,

scatter-plots 46916.5 1-year bond yield spread estimated composition 47116.6 1-year bond yield spread estimated

composition – only Germany-related factors 47216.7 EN factor loadings of HY, GeDeb, IP, Infl, Def and

Deb for the three countries as a function of maturity N 47316.8 Impulse response functions for Italy 47416.9 Impulse response functions for Spain 47516.10 Impulse response functions for Greece 476




xii List of figures

16.11 Path of Θt for maturities of 1, 5 and 10 years forItaly, Spain and Greece 478

16.12 1-year sovereign bond yield spread (% pa) – Italy,Spain and Greece 479

16.13 1-year sovereign bond yield spread (% pa) – Italyand Spain. Sample: January 1999 to December 2011 480

16.14 EN factor loadings of HY, GeDeb, IP, Infl, Def andDeb for Italy and Spain as a function of maturity N.Sample: January 1999 to December 2011 481

16.15 Impulse response functions for Italy – Sample:January 1999 to December 2011 482

16.16 Impulse response functions for Spain – Sample:January 1999 to December 2011 483

16.17 Deficit (ex-interest rate payments) as a percentageof GDP 484

17.1 Debt and interest rates in the USA, Germany and Italy 51817.2 Impact of a 1% debt/GDP shock on four different

variables, the USA 52117.3 Impact of a 1% debt/GDP shock on four different

variables, Germany 52217.4 Impact of a 1% debt/GDP shock on four different

variables, Italy 52217.5 Impact of fiscal shocks, comparative analysis:

1983:1–2009:4 vs 1983:1–2011:4 524




Tables

2.1 Standard deviations of interest rate changes page 222.2 Floating rate issuance of AAA-rated securities by sector 312.3 Composition of marketable US Federal government

debt held by the public 492.4 Activity in US Treasuries 494.1 Average annual rates of inflation, output growth,

and unemployment 1084.2 Estimates of the equation

pst = α + βgapurt−1 + δgapinft−1 + εt 1107.1 Fit and smoothness of yield curves of increasing

dimensionality 1797.2 Stability of yield curve dimensionality prior to QE 1817.3 Key QE announcements relating to UK government

bonds 1837.4 Effects of QE on the smoothness of yield curves of

increasing dimensionality 1847.5 Gilt purchases and the fit of the yield curve 1857.6 Variation is the yield curve explained by the first

four principal components 1918.1 Correlation coefficients of factor innovations (u)

and first differences of yields of particular maturities 2109.1 Summary statistics 2269.2 Effective spread parameters 2299.3 Policy rule parameters 2319.4 Pricing errors 2339.5 Gaussian term structure model 2349.6 Discrete term structure model 2359.7 Discrete support model – priced target risk 2379.8 Policy announcements 2008–2011 2439.9 Frequency ratio of changes in interest rates 247

xiii




xiv List of tables

10.1 Properties of evaluated yield curve models withregard to stylised facts 287

11.1 Normal times: January 2002–August 2007 31111.2 Crisis: August 2007–December 2008 31611.3 Extended period: December 2008–June 2010 32012.1 Consensus Taylor rule regressions 33712.2 Monetary policy uncertainty projections 35312.3 Treasury volatility risk premia 35513.1 Summary statistics of euro area yield curve data 36713.2 Volatility of survey and model inflation expectations 36913.3 The fitting of nominal bond yields under different

model specifications 37013.4 Parameter estimation (benchmark model specification) 37313.5 Model decomposition of spot breakeven inflation rates 37613.6 Bond liquidity measures and model-based

distortions in observed bond yields 37813.7 Decomposition of inflation compensation (BEIRs) 38014.1 Variance decomposition of yield spreads 40114.2 Forecasting core PCE inflation 40615.1 Economic variable surprises 42015.2a USA: impact of surprises 42515.2b Euro area: impact of surprises 42615.3a United States: yield pricing errors in basis points 43115.3b Euro area: yield pricing errors in basis points 43115.4 Parameter estimates 43215.5 Correlation of latent factors with observable variables 43315.6 Monetary surprises on nominal and real rates before

and after the Lehman collapse 43915.7 Macroeconomic surprises on nominal and real rates

before and after the Lehman collapse 44216.1 Autocorrelation of yields, spreads and the three first

principal components of yields or spreadsorthogonalised with respect to the macroeconomicand risk factors 463

16.2 Debt to GDP ratio from 2000Q1 to 2010Q3 –Granger causality tests 464

16.3 Parameter estimates – Germany 49316.4 Parameter estimates – Italy 49616.5 Parameter estimates – Spain 49816.6 Parameter estimates – Greece 50017.1 USA: quarterly data 52817.2 Unit root tests (1983:1–2009:4) 528




List of tables xv

17.3 Johansen trace cointegration test 52817.4 Germany: quarterly data 52917.5 Unit root tests (1983:1–2009:4) 52917.6 Johansen trace cointegration test 52917.7 Italy: quarterly data 53017.8 Unit root tests (1983:1–2009:4) 53017.9 Johansen trace cointegration test, USA 530




Contributors

M O R T E N B E C H Bank for International Settlements

A N D R E A B U R A S C H I University of Chicago

P R I S C I L L A B U R I T Y Pontifical Catholic University of Rio de Janeiro

A N D R E A C A R N E L L I Imperial College London

J A G J I T S . C H A D H A University of Kent and CIMF, University ofCambridge

M I C H A E L D E M P S T E R University of Cambridge

H A N S D E WA C H T E R National Bank of Belgium and University ofLeuven

A L A I N C . J. D U R R É European Central Bank and IÉSEG-School ofmanagement

PAT R I K E D S PA R R Visiting Fellow, Bank of England

J A C K E VA N S evalueFE

PA U L F I S H E R Bank of England

J E A N -S É B A S T I E N F O N TA I N E Bank of Canada

J U A N A N G E L G A R C Í A European Central Bank

L E O N A R D O I A N I A Louvain School of Management, National Bankof Belgium and KU Leuven

M I C H A E L A . S . J OY C E Bank of England

E L I Z A B E T H K L E E Federal Reserve Board

Y VA N L E N G W I L E R University of Basel

C A R L O S L E N Z Swiss National Bank

xvi




List of contributors xvii

M A R C O LY R I O Insper Institute for Education and Research

L U I G I M A R AT T I N University of Bologna

M A R C E L O M E D E I R O S Pontifical Catholic University of Rio deJaneiro

E L E N A M E D O VA Cambridge Systems

A L A I N M O N F O R T CREST

J E A N -PA U L R E N N E Banque de France

PA O L O PA E S A N I University of Rome, Tor Vergata

M A R C E L L O P E R I C O L I Bank of Italy

S I M O N E S A L O T T I Oxford Brookes University

L U C I O S A R N O City University London

F R A N K S M E T S European Central Bank and KU Leuven

V I K T O R S S T E B U N O V S Federal Reserve Board

J A M E S S T E E L E Y Aston Business School

D A N I E L T H O R N T O N The Federal Reserve Bank of St Louis

P H I L I P T U R N E R Bank for International Settlements

L U C I A N O V E R E D A Universidade Federal Fluminense

T H O M A S W E R N E R European Central Bank

PA U L W H E L A N Imperial College London




Foreword

Macroeconomics and finance are often housed within separate facul-ties in universities, and within separate divisions in central banks. Inthe real world, however, the two are intimately related. Savers, bor-rowers and investors meet through financial markets and institutions.Insurance markets support the pooling, distribution and diversificationof risks. Money markets underpin the most basic plumbing of mod-ern economies: the payment systems through which we pay for goodsand services, in different currencies, anywhere in the world. Banks com-bine the provision of credit, payments and liquidity-insurance services.Finance matters to macro, and vice versa!

Finance theory has made real progress over the past couple of decadesin modelling yield curves. Armed with, admittedly strong, ‘no arbitrage’assumptions that risk is priced consistently across the bond market at alltimes, this allowed a measure of the markets’ beliefs about the path ofshort-term interest rates to be derived from the term structure of for-ward interest rates. Together with similar information from index-linkedgovernment debt, this unlocked the extraction of estimates of inflationexpectations at different horizons - vitally important for monetary policymakers, and also for legislators and the public in holding independentcentral banks accountable for the price-stability goal they have set us.

Although no-arbitrage provides a means of deriving risk premia, mea-suring and explaining the various risk premia priced into different finan-cial contracts remains one of the biggest challenges for macro-finance.This is not only a technical question for finance. Macroeconomic policy-makers need to understand the real economy counterparts to identifiedshifts in risk premia. For example, does a fall in long-term rates driven bya compression in term premia have the same implications for investmentprospects as a fall driven by lower expected future central bank interestrates?

The importance of questions of that kind has been underlined bycentral banks’ use of quantitative easing given that our short-term policy

xix




xx Foreword

interest rates are at, or around, their lower bound. Separately from anysignals that QE might give about the likely path of the policy rate, poli-cymakers have purchased longer-term bonds in order to influence termpremia directly and, through portfolio-balance effects, the price of otherassets. We have therefore needed rich models in order to understandthose features of the real world - preferred habitats, imperfect arbitrage,and the associated balance sheet constraints amongst intermediaries -that make this possible, and to identify and forecast the effects of a givenstock of asset purchases.

The effect of the size and composition of central bank balance sheetson asset prices touches on old debates about the overlap between debtmanagement operations and monetary conditions. A 1998 Bank of Eng-land conference1 concluded that, though changes in debt managementpolicy were unlikely at the margin to have first-order effects, it was ‘lessclear that large changes in the quantity or composition of debt [would]not have implications for monetary conditions’. Fifteen years on, theinfluence of quantitative easing on long-term interest rates looks to haveover-turned previous scepticism about the effectiveness of the kind ofoperations employed in the Federal Reserve’s ‘Operation Twist’ in theearly 1960s.

There is an accumulating body of evidence that central banks’ influ-ence over risk-premia extends beyond unconventional monetary pol-icy instruments such as quantitative easing. The prevailing level andexpected path of the risk-free interest-rate matters too. Movements inlong-term (forward) interest rates following changes in central bank pol-icy rates appear consistent with a risk channel of conventional monetarypolicy, with cuts in short-term interest rates bringing about a compres-sion in term premia as investors adjust their portfolios in a search foryield.2 Monetary policymakers need to be alive and open to the possibil-ity that their actions may well have a bearing on risk-taking in financialmarkets. That need not imply that monetary policy must routinely beadjusted actively to meet a financial stability objective. Where risks tofinancial stability emerge, financial policy tools - the regulation of banksand other institutions - can be used to address the problem more directly.

Incorporating a role for changes in risk premia in macroeconomic fluc-tuations is, I believe, vital to a deeper understanding of the drivers andimplications of developments within financial markets. In addition to

1 See Crystal (1999), ‘Government Debt Structure and Monetary Conditions’ for arecord of the conference proceedings.

2 See Hanson and Stein (2012), ‘Monetary Policy and Long-Term Real Rates’, HarvardBusiness School Working Paper, No. 13–008, and Tucker (2012), ‘National Balancesheets and macro policies: lessons from the past’.




Foreword xxi

accounting for term premia, we need macro-models that properly incor-porate credit risk, including the non-linearities associated with default.At its core, default is a boundary condition where debtors are unable,or simply unwilling, to service their outstanding obligations given thevalue of their assets, including their prospective future incomes. A real-istic model of credit risk needs to be able to capture the sharp pick up incredit losses that can occur when asset values are sufficiently depressed,and trace through the effects on intermediaries’ net worth. Models wheredifferent agents’ financing costs vary with net worth, but without anyprospect of default, are probably not worth much. Moreover, we prob-ably need models with heterogeneity in levels of indebtedness acrosshouseholds, firms and, possibly, also intermediaries.

Real progress also requires macro-finance to re-engage with banking.“Money and banking” used to be at the core of university courses inmacroeconomics but, even before the so-called ‘Great Stability’, cameto be regarded as old fashioned. Sadly, the same was true in parts ofcentral banking. The costs of the crisis and the difficulties in gener-ating recovery have put beyond doubt, once again, the importance ofbanks and other key financial intermediaries to market liquidity, assetprices, the allocation of resources to productive ends, and householdand firms’ behaviour. It is very important that UK-based researchersshould be active in this field, and this conference engaged with a num-ber of the issues. With short-term interest rates close to their effectivelower bound, understanding central banks’ ability to influence aggregatedemand by acting through a broader range of instruments is crucial tounderpinning economic recovery. Further ahead, richer models of theconnections amongst banking (including shadow banking), risk premiaand macro-economic fluctuations would help to avoid similar crises inthe future. This timely conference volume addresses issues that are cen-tral both to the research agenda for macroeconomics and finance and tothe decisions that policymakers will face as we emerge from the crisis.

Paul Tucker, former DeputyGovernor of the Bank of England




Preface

The monetary transmission mechanism relies heavily on the impact ofthe current level and expected path of policy rates on longer term inter-est rates paid on government liabilities and a wide constellation of retailand wholesale borrowings. It is mostly this transmission of interest ratesalong the maturity and risk spectrum that gives monetary policy its trac-tion on the wider economy. And yet much of this transmission wasassumed away in many macroeconomic models used prior to the eco-nomic crisis: often, even those who modelled the links did not necessarilydevelop models in which longer term interest rates reflected liquidityor default risk. The problems of this assumption emerged with someforce as the evolving financial and sovereign debt crisis in the euro areabrought to the fore the intimate relationship between the macroeconomiceconomy and the financial system. In turn, policymakers have had, inturn, to rethink many assumptions that have been made about the rela-tionship between the state, monetary policy and the financial sector. Theextensive and persistent use of near zero interest rates at the short endof the term structure has significantly reawakened research and policyinterest in the link between the yield curve and the macro economy.

The development of extraordinary policies such as quantitative andcredit easing, as well as extended open market operations such as Oper-ation Twist, have been designed to alleviate premia in longer terminterest rates. And yet we remain at some distance from understand-ing the impact of signalling and purchases on many key interest rates.The conference we held at Clare College Cambridge in September 2011brought together many economists in academia, financial markets andcentral banks to look afresh at these relationships and we are pleased tosponsor the publication of the contributions, which have benefitted fromthe comments of the conference discussants and also many anonymousreferees.

JAGJIT S. CHADHA AND SEAN HOLLY

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