European Central Bank publishes working paper on time-varying risk aversion and inflation risk premiums in an equilibrium term structure model

The European Central Bank has published Working Paper No 3012 presenting an equilibrium macro-finance term structure model that links movements in real and nominal yield curves to time variation in risk aversion and in the correlation between inflation and consumption. The paper derives analytical pricing solutions for real and nominal bonds and uses the framework to separate expected short-rate paths from risk premiums, noting that the findings reflect the authors’ views rather than those of the ECB. The model combines Epstein-Zin recursive preferences with a time-varying risk aversion process and a state-dependent inflation-consumption correlation intended to capture shifts between supply-shock- and demand-shock-dominated regimes. A trend-cycle specification of consumption with hysteresis effects is used to generate an upward-sloping real yield curve on average, while changes in the inflation-consumption correlation primarily move nominal yields and changes in risk aversion primarily move real yields while amplifying nominal effects. Estimated on US quarterly data from 1961 to 2019 using macro data, nominal yields, inflation-linked bond yields and survey expectations, the results point to substantial time variation in inflation risk premiums, with positive values earlier in the sample (especially during the 1980s) and negative values from the start of the new millennium, alongside a shift from supply-shock dominance in the late 1970s and 1980s to a more demand-dominated pattern since the 1990s.