Monetary policy and the slope factor in empirical term structure estimations

This paper examines the empirical relationship between the movement of the slope factor in term structure of nominal interest rates and exogenous monetary-policy shocks in the U.S. after 1982. Using first a six-variable VAR model and then a GMM estimation model of the "Taylor rule," I estimate the exogenous monetary-policy shocks implied by each of them in the U.S. during this period. Meanwhile, a two-factor model is used to extract the underlying slope factor of the term structure. Results from the correlation study suggest that there is strong correlation between the slope factor and the exogenous monetary-policy shocks. Moreover, monetary-policy shocks can explain a large part of variability of the slope factor. This study provides strong evidence in support of Knez, Litterman and Scheinkman (1994)'s conjecture on the relation between the slope factor and the Federal Reserve policy, and is also consistent with the results in Wu (2001a)'s general-equilibrium based simulation study.