No-Arbitrage Taylor Rules with Switching Regimes

We develop a continuous-time regime-switching model for the term structure of interest rates, in which the spot rate follows the Taylor rule, and government bonds at different maturities are priced by no-arbitrage. We allow the coefficients of the Taylor rule and the dynamics of inflation and output gap to be regime-dependent. We estimate the model using government bond yields and find that the Fed is proactive in controlling inflation in one regime but is accommodative for growth in another. Our model significantly improves the explanatory power of macroeconomic variables for government bond yields. Without the regimes, inflation and output can explain less than 50% of the variations of contemporaneous bond yields. With the regimes, the two variables can explain more than 80% of the variations of contemporaneous bond yields. Proactive monetary policies are associated with more stable inflation and output gap and therefore could have contributed to the “Great Moderation.”