Macro-Finance Model of the Yield Curve: A Macroeconomic Interpretation using Principal Components Analysis

We employed Principal Component Analysis (PCA) to model the key factors influencing the British yield curve, integrating these factors with macroeconomic variables (output, inflation, and the monetary rate) within a recursive Vector Autoregressive (VAR) framework. Our analysis explored the dynamics of these factors through impulse response functions and forecast variance decomposition. We constructed various models using both differenced and raw data, examining distinct time periods: 1993-2006 and 2007-2024. This approach allowed us to assess the interaction between yield curve factors and macroeconomic variables, and to evaluate the robustness and predictive power of our models across different economic conditions. We observed a shift in the monetary policy behaviours in managing the yield curve. Prior to the GFC, monetary policy focused on stabilizing the shape of the yield curve, emphasizing growth and investment rather than inflation control. Post GFC, the central bank’s strategy pivoted towards managing short-term liquidity and accommodating changes in the yield curve’s slope and curvature, reflecting a heightened sensitivity to inflation and a constrained ability to influence long-term interest rates.