Monetary policy uncertainty and investor expectations

How does monetary policy uncertainty affect the behavior of market participants? In a New-Keynesian DSGE model with Epstein-Zin preferences, an increase in interest rate uncertainty is found to increase precautionary savings for households, and depress output, inflation and the short- and long-term asset yields. These effects are similar to a negative demand shock. The monetary policy uncertainty shock is calibrated using ex-ante uncertainty of investors about the future changes in Treasury yields, extracted from Options and Futures data. Incorporating the monetary policy uncertainty shock is also found to lower the term premium generated by the model, relative to the case without stochastic volatility in the interest rate rule. (C) 2015 Elsevier Inc. All rights reserved.