A Terminal Rate Approach to Dissecting Term Premia

We parameterize the yield curve using four factors that directly capture the term structure of term premia and the risk-free expectations curve. By explicitly integrating a convergence point (the terminal rate) for the short rate, our model is uniquely positioned to provide more insightful reflections on the state of the economy, capturing investors’ risk tolerance, expectations regarding inflation, monetary policy shifts, and other macroeconomic factors. Its robustness and reliability are demonstrated by accurately replicating term premia from established models such as <xref>Joslin, Singleton, and Zhu (2011)</xref> (JSZ), <xref>Adrian, Crump, and Mönch (2013)</xref> (ACM), and <xref>Diebold and Li (2006)</xref> (DNS), while revealing that these models imply significant volatility in estimated real terminal rates over the past four decades. The terminal rate model (TRM) that we propose aligns closely with the <italic>r</italic>* gauge (<xref>Holston, Laubach, and Williams 2017</xref>) before the 2008 recession, indicating its effectiveness in capturing economic developments. The comparative performance of the TRM against ACM, JSZ, and DNS models underscores its potential utility in forecasting and policy analysis, particularly in understanding the impact of significant economic shifts.