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

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.