1. Government spending news and the term structure of interest rates Nicola Cofelice Sarah Zoi Supervisor: Luca Gambetti 30/06/2014, Barcelona

2. Research question What is the effect of a government spending shock on the term structure of interest rates? Why is it important? Financial markets Policy evaluation Role in the last financial crisis Effectiveness of fiscal policies for recovery European sovreign debt crisis 2

3. Theory and empirical evidence Economic theory says Interest rates Government spending Empirical evidence on US data Evans and Marshall (2002), Uhlig and Mountford (2002 and 2008) Government spending Interest rates 3

4. OVERVIEW ORIGINAL VAR 1st GOVT SPENDING 2nd GDP 3rd INFLATION 4th 3 Months TB 5th 5 Years Bond 6th 10 Years Bond 1st shock (Cholesky): Surprise shock on GOVT SPENDING IRF analysis Surprise shock Interest rates UPDATED VAR 1st SPENDING NEWS 2n d GOVT SPENDING 1st shock (Cholesky): Anticipated shock on GOVT SPENDING IRF analysis Anticipated shock Interest rates 4 ISSUE: Surprise shock not properly identified!

5. 6 VARIABLES VAR Bayesian VAR (4) Cholesky identification US data Quarterly frequency 1981:Q3 2013:Q4 1st GOVt SPENDING 2nd GDP 3rd INFLATION 4th 3 Months TB 5th 5 Years Bond 6th 10 Years Bond Implied assumption: Government spending shock is a SURPRISE SHOCK 5

6. FISCAL FORESIGHT - II AGENTS INFORMATION SET ECONOMETRICIAN S INFORMATION SET NON FUNDAMENTALNESS 6 ISSUE: Surprise shock not properly identified!

7. SPENDING NEWS - I QUESTION is our Surprise Shock on govt spending forecastable? TEST FOR NON-FUNDAMENTALNESS Forni e Gambetti (2012) Survey Professional Forecasters 7

8. SPENDING NEWS - I QUESTION is our Surprise Shock on govt spending forecastable? Do not reject H0 SSt is actually a surprise for economic agents! Do reject H0 SSt can be forecasted by economic agents! Non Fundamentalness Supposed Surprise shock Survey Professional Forecasters as proxy of expectation 8 H0: = 0 (F-test) TEST FOR NON-FUNDAMENTALNESS Survey Professional Forecasters = + +

9. SPENDING NEWS - II How to define SPENDING NEWS? 9 + = + + = forecasted growth of government spending in period t for period t+h revision of forecasted growth of government spending = SPENDING NEWS = + +

10. SPENDING NEWS - III 10 BERLIN WALL FALL WAR AFGHANISTAN

11. VAR with SPENDING NEWS UPDATED VAR MODEL 1st SPENDING NEWS 2n d GOVt SPENDING 3rd GDP 4th INFLATION 5th 3 Months TB 6th 5 Years Bond 7th 10 Years Bond 1981:III 2013:IV PREVIOUS VAR MODEL 1st GOVt SPENDING 2n GDP d 3rd INFLATION 4th 3 Months TB 5th 5 Years Bond 6th 10 Years Bond 1981:III 2013:IV 4 lags 11

12. IRFs NEWS SHOCK => OTHERS Bayesian VAR, 68% confidance bands, 2000 draws, Cholesky identification 12

13. Variance decomposition: Spending shocks on interest rates LONG TERM INT. RATE NEWS SHOCK more relevant than SURPRISE SHOCK 13 SHORT TERM INT. RATE NEWS SHOCK and SURPRISE SHOCK not so relevant

14. Conclusions Traditional identification of fiscal shocks may be affected by non-fundamentalness Accounting for fiscal foresight solves the puzzling behavior of interest rates 1% News Shock ~ 0.1% 0.3% interest rates Fiscal foresight shock is relevant to explain variability of long term interest rates

15. Government spending news and the term structure of interest rates THANK YOU!

16. Test for Non Fundamentalness SSt = const + SPFt-h+t H0: = 0 (F-test) p < : Surprise shock is forecastable (red value) p > : Surprise shock is not forecastable (black value) 16