John Cochrane has an interesting paper/blog post about forecasting interest rates. I'm not sure I've absorbed it all quite yet, but I have a quick take.

The key point Cochrane is making is that the reason adding an inflation term to forecast models of interest rates improves them is really just because inflation has a trend -- a trend that roughly follows the first principal component term (PC1 at the link). Adding a trend (with principal components) allows you to get a really good fit -- and in fact it is this trend that captures most of the forecasting capability of the model. Cochrane says this means there a strong one-factor model of bond yields across all maturity. Basically, one interest rate describes them all pretty well.

This is just a cheesy overlay on the principal component graph, but that first principal component seems to be well described by the information equilibrium model:

Purple = Ten year rate

ReplyDeleteBlack = IT model fit

Then the 1st 3 "principal components" (PCs) described here and shown in Figure 2 are:

Blue = PC1

Red = PC2

Yellow = PC3

Just posting for the benefit of anybody else wondering what those colors were (it took me a minute or two to catch on).

My quick take might have been a little too quick. Thanks for the legend.

DeleteJason, has Cochrane ever responded to on of your comments?

ReplyDeleteNot that I know of, but it gets though moderation which is a good first step. And for some reason a lot of people click on links in comments on his blog. Comparable to Marginal Revolution, which implies a really high engagement rate on Cochrane's blog assuming his traffic is an order of magnitude less.

DeleteI notice that your latest comment is still his only comment on his latest post. No response yet.

Delete