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Back to the 1980s or not? The drivers of inflation and real risks in Treasury bonds

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  • Pflueger, Carolin

Abstract

This paper shows that supply shock uncertainty interacts with the monetary policy rule to drive bond risks in a New Keynesian asset pricing model. In my model, positive nominal bond-stock betas emerge as the result of volatile supply shocks but only if the monetary policy rule features a high inflation weight. Habit formation preferences generate endogenously time-varying risk premia, explaining the volatility and predictability of bond and stock excess returns in the data, and implying that bond-stock betas price the expected equilibrium mix of shocks rather than realized shocks. The model explains the change from positive nominal and real bond-stock betas in the 1980s to negative nominal and real bond-stock betas in the 2000s with a shift from dominant supply shocks and an inflation-focused monetary policy rule, to demand shocks in the 2000s. Post-pandemic nominal and real bond-stock betas are explained with dominant supply shocks and a late increase in the monetary policy inflation coefficient.

Suggested Citation

  • Pflueger, Carolin, 2025. "Back to the 1980s or not? The drivers of inflation and real risks in Treasury bonds," Journal of Financial Economics, Elsevier, vol. 167(C).
    • Handle: RePEc:eee:jfinec:v:167:y:2025:i:c:s0304405x25000352
    DOI: 10.1016/j.jfineco.2025.104027
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    Keywords

    Bond betas; Stagflation; Soft landing; Supply shocks; Demand shocks; Monetary policy; New Keynesian; Time-varying risk premia;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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