Working Paper

Accounting for Low Long-Term Interest Rates: Evidence from Canada


Abstract: In recent decades, long-term interest rates around the world have fallen to historic lows. We examine this decline using a dynamic term structure model of Canadian nominal and real yields with adjustments for term, liquidity, and inflation risk premiums. Canada provides a useful case study that has been little examined despite its established indexed debt market, negligible distortions from monetary quantitative easing or the zero lower bound, and no sovereign credit risk. We find that since 2000, the steady-state real interest rate has fallen by more than 2 percentage points, long-term inflation expectations have edged down, and real bond and inflation risk premiums have fluctuated but shown little longer-run trend. Therefore, the drop in the equilibrium real rate appears largely to account for the lower new normal in interest rates.

Keywords: liquidity risk; financial market frictions; r-star; affine arbitrage-free term structure model;

JEL Classification: C32; E43; E52; G12; G17;

https://doi.org/10.24148/wp2020-35

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Provider: Federal Reserve Bank of San Francisco

Part of Series: Working Paper Series

Publication Date: 2020-12-30

Number: 2020-35

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