Yield Curve and Monetary Policy Expectations in Small Open Economies

Abstract

This paper estimates a New Keynesian dynamic stochastic general equilibrium (DSGE) model in small open economies using the yield curve data as well as standard macro data. The DSGE model is estimated on the data of three inflation-targeting small open economies (Australia, Canada, and New Zealand) using Bayesian methods. We find that the long-end of the yield curve is highly correlated with the current and future short-term interest rates determined by domestic central banks. Yield curve data are particularly informative about the future stance of monetary policy in Australia and Canada in that the correlation between the model-implied monetary policy expectations and the ex-post realized policy interest rates increases when the yield curve data are used in estimation. In New Zealand, estimation results based on only macro data produce a high correlation between the model-implied interest rate expectations and the ex-post realized interest rates because information from the yield curve has been explicitly incorporated in monetary policy decisions. We also document that a persistent shock to the inflation target driving the average level of the yield curve in these three countries is highly correlated with long-horizon inflation expectations in the U.S., indicating stronger financial linkages.