Macroeconomic Drivers and the Pricing of Uncertainty, Inflation, and Bonds

Brandyn Bok, Thomas Mertens and John Williams

No 1011, Staff Reports from Federal Reserve Bank of New York

Abstract: This paper analyzes a new stylized fact: According to financial market prices, the correlation between uncertainty shocks, as measured by changes in the VIX, and changes in break-even inflation rates has declined and turned negative over the past quarter century. It rationalizes this uncertainty-inflation correlation within a standard New Keynesian model with a lower bound on interest rates combined with a decline in the natural rate of interest. With a lower natural rate, the likelihood of the lower bound binding increased and the effects of uncertainty on the economy became more pronounced. In such an environment, increases in uncertainty raise the possibility that the central bank will be unable to eliminate inflation shortfalls following negative demand shocks. As a result, the observed decline in the correlation between uncertainty and inflation expectations emerges. Average-inflation targeting policies can mitigate the longer-run effects of increases in uncertainty on the real economy.

Keywords: interest; uncertainty; inflation; equilibrium; lower bound; shocks; liquidity (search for similar items in EconPapers)
JEL-codes: E52 (search for similar items in EconPapers)
Pages: 44
Date: 2022-04-01
New Economics Papers: this item is included in nep-cba, nep-dge and nep-mac
Note: Revised May 2022.
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Working Paper: Macroeconomic Drivers and the Pricing of Uncertainty, Inflation, and Bonds (2022)
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