Comment and Discussion

Glenn D. Rudebusch:

This paper by David Backus and Jonathan Wright examines a timely topic of interest to macroeconomists, financial economists, and the general public of long-term savers and investors. They investigate the recent episode of continuing low long-term interest rates—a behavior that appears to some to be a "conundrum" given that short-term rates worldwide have been rising. For example, in the United States, while the Federal Reserve raised the federal funds rate from 1 percent in June 2004 to 5¼ percent in December 2006, the rate on ten-year U.S. Treasury notes actually edged down, on balance, from 4.7 percent to 4.6 percent. This directional divergence between short- and long-term rates is at odds with historical precedent and appears even more unusual given other economic developments at the time, such as a solid economic expansion, a falling unemployment rate, rising energy prices, and a deteriorating federal fiscal situation, all of which have been associated in the past with higher long-term interest rates rather than lower.

Of course, determining whether recent long-term interest rate movements truly represent a puzzle requires a theoretical framework that takes into account the various factors that affect long-term rates. The paper takes a joint macro-finance perspective on this problem, which, as much recent research suggests,¹ is a promising strategy that can capture two broad sets of determinants of long-term rates. In particular, from a macroeconomic perspective, the short-term interest rate is a policy instrument under the direct control of the central bank, which adjusts that rate to achieve its macroeconomic stabilization goals. Therefore financial market participants' understanding of central bank behavior, along with their views of the future direction of the economy, will be an important element in forming their expectations of future short-term rates, which, in turn, will be key in pricing longer-term bonds. For example, the widespread view over the past few years that the Federal Reserve had inflation pretty well in hand has undoubtedly helped hold down long-term bond rates. In addition, a finance perspective, which stresses the importance for bond pricing of investor perceptions of risk, is also likely to be a crucial element in assessing whether there is any bond rate conundrum. Indeed, many have suggested that a reduction in the risk premium is responsible for recent low bond rates. Such a reduction may be attributable to changes in the amount of risk or to changes in the pricing of that risk, and numerous factors have been suggested that could have induced such changes.

The paper identifies a declining term premium, and in particular a declining inflation risk premium, as the proximate source of the recent fall in long-term interest rates. This seems reasonable, but in some sense one can interpret the authors' analysis as showing that there has been no conundrum. The estimated term structure models in the paper seem to fit the recent episode as well as the earlier sample (their figures 9 and 10); that is, the recent episode is not so puzzling that it requires a shift in model coefficients or produces unusually large residuals. The analysis in the paper has essentially defined the "conundrum" away. Of course, such a conclusion would require that the authors had the correct model of interest rates and the term premium, which is far from certain. It seems useful to examine other term structure representations in order to evaluate the robustness of the authors' conclusions; therefore my figure 1 plots five different measures, taken from the literature, of the term premium in the zero-coupon nominal ten-year U.S. Treasury yield:²

• — VAR measure: This is obtained from a standard, three-variable, macroeconomic vector autoregression (VAR), comprising four lags each of the unemployment rate, quarterly inflation in the consumer price index, and the three-month Treasury bill rate. This VAR can be used in each quarter to forecast the short-term rate over the next ten years, which, after averaging, provides one estimate of the risk-neutral ten-year rate. The difference between the observed ten-year rate and that risk...