Disagreement about the Business Cycle and the Term Structure of Interest Rates

The level, slope, curvature and volatility of yields and the predictability of nominal bond returns and the high persistence of changes in their yields are important features of government bonds (U.S. Treasuries). While there are many sophisticated reduce d form models that are successful in explaining these features of the data the economic mechanisms behind these empirical facts remain underexplored. We will study the equilibrium term structure of nominal interest rates with heterogeneous external habit forming preferences and inflation uncertainty. Investors may or may not know the dynamics of aggregate nominal consumption growth but have different beliefs about expected inflation and hence the dynamics of inflation. We show that this difference and ha bit formation may lead to disagreement whether the economy is in a recession or an expansion. The equilibrium nominal stochastic discount factor is determined in closed form and the effects of aggregate risk aversion, difference in beliefs, habit, and inf lation on the nominal short rate and the nominal market price of risk are explored. Moreover, we provide simple formulas for nominal bond prices, real bond prices, and the inflation risk premium that can be numerically evaluated using Monte Carlo simulati on techniques. We show that heterogeneity in preferences among investors with external non-addictive habit forming preferences produce a good fit of the level and the curvature of the nominal term structure of interest rates. In addition, beliefs about e xpected inflation help to reproduce the predictability of nominal bond returns.