Demographics and the behavior of interest rates

Interest rates are very persistent. Modelling the persistent component of interest rates has important consequences for forecasting. Factor models of the term structure are restricted VAR models that project over a long-horizon the one-period risk free rate to obtain yields at longer horizon as the sum of the expected future monetary policy and the term premia. The included factors are typically mean reverting and the equilibrium real rates are considered constant (think, for example, of the standard Taylor-rule), partial adjustments to equilibrium yields are then used to rationalize the persistence in observed data. As a result the empirical models feature a very high level of persistence that makes long-horizon predictions inherently inaccurate. This paper relates the common persistent component of the U.S. term structure of interest rates to the age composition of population.