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

Bok, Brandyn; Mertens, Thomas M.; Williams, John C.

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

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;

JEL Classification: E52;