Investigating United Kingdom's monetary policy with Macro-Factor Augmented Dynamic Nelson-Siegel models

We employ the Dynamic Nelson-Siegel (DNS) model augmented with macroeconomic factors to investigate interactions of yields, real economic activity, and monetary policy in the United Kingdom. By explicitly accounting for the structural break during the early 90s at the time the UK exited the Exchange Rate Mechanism of the European Monetary System, we document a number of interesting findings. Specifically, there is evidence of a great moderation in the volatility of the term structure post-1992. At the same time, there is a significant reduction of the loading parameter in the DNS model, which suggests a greater influence of monetary policy and economic activity on the UK bond market. We find that the level and slope yield curve factors are related to inflation expectations and monetary policy, respectively, as has been found in related literature. Interestingly, the curvature factor which has been elusive in its relationship to macroeconomic fundamentals is found to be more strongly related to economic activity post-1992.