Inflation and real short-term interest rates - A Kalman filter analysis of the term structure

This paper applies the Kalman filter technique to look at the relationship among real interest rates, inflation, and the term structure of interest rate under the expectations hypothesis. Using quarterly data from 1960:1 to 1991:1 for inflation, three month nominal short term interest rates and long term yields with maturities from one to five years, this paper finds that the expectations hypothesis of the term structure holds up well for the data under the assumptions of a time-varying premium and a random-walk real interest rate. In other words, a reconciliation of the expectations hypothesis with the data is attained by assuming time-varying term premium and non-stationary real interest rate.     

Risk-aversion and the term structure of real interest rates

The term structure of real interest rates is studied in the context of a consumption-based general-equilibrium model. It is shown that the expectations hypothesis is approximately satisfied for low interest rate volatility. Otherwise the term premia are generally positive.     

Loss aversion and the term structure of interest rates

This article studies how the loss averse behaviour affects the term structure of real interest rates. Since the pro-cyclical conditional expected marginal rate of substitution, implied from the US consumption data, is consistent with the proposition of loss aversion, we incorporate the loss averse behaviour of prospect theory into the consumption-based asset pricing model. Motivated by the similarity between habit formation and the prospect theory utility, habit formation is exploited to determine endogenously the reference point of this behavioural finance utility. The highly curved characteristic of the term structure of real interest rates can thus be captured by the additional consideration of loss aversion. This model also fits the downward sloping volatility of the real yield curve in the data of US Treasury Inflation-Protection Securities (TIPS). Moreover, depending on the effective risk attitude of the representative agent with the loss averse behaviour of prospect theory, our model is capable of generating a normal or an inverted yield curve.     

Financial integration and the term structure of interest rates

This paper presents a model of the term structure for an open economy. A flexible VAR approach is used to model macroeconomic growth, inflation, short rate and the yield spread. Then the term structure is built given restrictions implied by the no-arbitrage condition. Contrary to previously proposed macrofinance models of the term structure, the model suggested here explicitly accounts for financial and real spillovers between economies. As documented in the paper, foreign macroeconomic factors contain a lot of information about the domestic term structure of yields. Put to data, the model explains the dynamics of yields very well. It provides better out-of-sample forecasting results than the closed economy models. Openness induces more variability in the estimated term premia of yields with shorter maturities.     

Inflation targeting and real exchange rates: A bias correction approach

This paper examines whether inflation targeting (IT) influences purchasing power parity (PPP) by a bias correction approach under cross-sectional dependence. The recursive mean adjustment (RMA) method proposed by So and Shin (1999) and Shin and So (2001) is employed to correct a downward bias in half-life estimates of real exchange rates. More importantly, the empirical results show that IT lowers variability of real exchange rates and plays an important role in providing favorable evidence for long-run PPP.     

The expectations hypothesis, term premia, and the Canadian term structure of interest rates

In this paper monthly data are used over the period 1960:7 to 1995:12 to examine the determinants of term premia implicit in the Canadian T-bill term structure of interest rates. In sharp contrast to U.S. evidence, the conditional variances of Canadian macroeconomic variables are found to be insignificant predictors of term premia in the Canadian T-bill term structure. The conditional variances of U.S. macroeconomic variables, however, are found to be important determinants of Canadian term premia. JEL Classification: E43, G1
L'hypothese des anticipations, les primes de temps et la structure temporelle des taux d'intérêt canadiens. Ce mémoire utilise des données mensuelles de juillet 1960 à décembre 1995 pour examiner les déterminants des primes de temps implicites dans la structure des taux d'intérêt pour les bons du trésor canadiens. Contrairement à ce que l'on trouve aux Etats-Unis, il semble que les variances conditionnelles des variables macroéconomiques canadiennes ne sont pas des prédicteurs utiles de ces primes. Cependant, il appert que les variances conditonnelles des variables macroéconomiques des Etats-Unis sont des déterminants importants de ces primes.     

The behaviour of expected short-term real interest rates in the UK

The existence of persistent technical inefficiency offers the opportunity for a ‘free lunch’ not typically implied by the neoclassical theory of the firm. When external effects are related to the use of particular inputs, reduction of persistent technically inefficient levels of input use represents a means of reducing external impacts. An important example is found in agriculture where substantial environmental impacts are generated by particular inputs. Within this context, this paper considers the usefulness of data envelopment analysis (DEA) for estimation of potential input reductions and assessment of potential reductions of environmental impacts of agricultural inputs. An application for French cereal production provides estimates that indicate that substantial potential exists for reduction of input use and environmental impacts.     

Incomplete markets,liquidation risk,and the term structure of interest rates

We analyse the term structure of interest rates in a general equilibrium model with incomplete markets, borrowing constraint, and positive net supply of government bonds. Uninsured idiosyncratic shocks generate bond trades, while aggregate shocks cause fluctuations in the trading price of bonds. Long bonds command a “liquidation risk premium” over short bonds, because they may have to be liquidated before maturity – following a bad idiosyncratic shock – precisely when their resale value is low – due to the simultaneous occurrence of a bad aggregate shock. Our framework endogenously generates limited cross-sectional wealth heterogeneity among the agents (despite the presence of uninsured idiosyncratic shocks), which allows us to characterise analytically the shape of the entire yield curve, including the yields on bonds of arbitrarily long maturities. Agents? desire to hedge the idiosyncratic risk together with their fear of having to liquidate long bonds at unfavourable terms implies that a greater bond supply raises the level of the yield curve, while an increase in the relative supply of long bonds raises its slope.     

Budget deficits,short-term real interest rates and the specification of expected inflation: an empirical investigation

The purpose of this paper is to illustrate whether empirical estimates of the effects of budget deficits on short-term real interest rates are sensitive to the choice of the expected inflation variable. Survey data on expected inflation and the rational expectations method described by Mishkin (1981) are used to construct two measures of the short-term real interest rate. Results for two previous studies on this deficit-interest rate relationship are re-estimated using these measures of expected inflation and the interest rate variables. Additional results reported in this paper further indicate that empirical estimates of the interest rate effects of budget deficits are sensitive to the choice of the expected inflation variable. In addition to the choice of the inflation variable, a number of other robustness tests are included. We are able to conclude that (1) increases in budget deficits do not generally raise short-term real interest rates and (2) short-term real interest rates are not independent of the expected inflation variable.

The rate of interest is always based upon expectation, however little this may be justified by realization. Man makes his guess of the future and stakes his action upon it … Our present acts must be controlled by the future, not as it actually is, but as it appears to us through the veil of chance (Fisher, 1907, p. 213).     

An empirical note on Euro market interest rates,domestic interest rates and the expectations theory of the term structure

An empirical analysis of recent monthly data for 8 currencies indicates that the performance of the expectations theory to explain the short term maturity spectrum of Euro interest rates is rather good in most cases and that it is not related to the degree of integration of Euro and domestic markets.     

Australian monetary growth and short-term nominal interest rates: an interest parity efficient markets approach

The relationship between monetary growth and nominal interest rates continues to attract considerable attention in the literature. Mishkin (1982) has found that, by explicitly imposing market efficiency in an interest rate model for the US, empirical analysis does not support the ‘Keynesian’ proposition that increases in monetary growth are associated with reductions in short-term rates. In this paper a similar theoretical structure is used but, unlike Mishkin, explicit account is taken of the fact that Australia's capital market is closely integrated with international money markets. Incorporating this into the interest rate model indicates there is some empirical support for the ‘Keynesian’ proposition in the Australian case. The analytical model also incorporates a measure of interest rate volatility to account for the risk premium present in the forward rate for 90 day bank bills.     

Inflation,interest and exchange rates in the transition1

Central and Eastern European economies have made extraordinary progress in their trade and exchange regimes. Surprisingly, instant convertibility was established for a great variety of exchange rate regimes. In spite of diversity, all these countries have followed a common pattern: severe initial undervaluation - the cost of speed and unrestricted trade - followed by rapid real revaluation and incipient protectionism. Since 1994 in many cases an embarrass de richesse has appeared: high capital inflows which are either inflationary or costly to sterilize. A major cause of these flows - or at any rate of the high cost of sterilization - is the presence of significant interest rate differentials higher than required to cover the risk of devaluation. These are the necessary consequence of a policy of positive real interest rates and of real revaluation from excessively undervalued exchange rates. Lower interest rates are recommended, both to stem financial capital inflows and to reduce the cost of their sterilization.     

Regime shifts in the Danish term structure of interest rates

Within a bivariate VAR model allowing for two-state Markov regime switching we test and evaluate the Expectations Theory (ET) of the term structure using Danish 1- and 3-months interest rates covering the period 1976–1997. A regime-shift approach is used in order to account for the change in monetary policy and the 1992–93 exchange rate crises that occured during this period. The basic findings are that these episodes did change the term structure, and, although we do find departures from the ET, several of the implications of the theory are consistent with the data, especially in the later part of the sample. First version received: June 1997/Final version received: March 1998     

The term structure of interest rates within a production economy: A parametric example

The behavior of the term structure of interest rates is studied analytically within a simple stochastic growth model. It is shown that the qualitative characteristics of interest rate behavior within this setting do not differ from those in more general settings which have been studied previously through numerical methods. Specifically, it is demonstrated that interest rates are countercyclical; the yield curve will invert in recessions, but, on average will have a positive slope implying a positive term premium.     

Stabilizing an unstable economy: Fiscal and monetary policy,stocks, and the term structure of interest rates

Monetary and fiscal policy measures have been applied in order to avert the financial market collapse and counteract the global recession. In this paper we present an integrated macromodel which in particular focuses on the financial markets. We use a Tobin-like macroeconomic portfolio approach, and the interaction of heterogeneous agents on the financial market to characterize the potential for financial market instability. We show that specific but unorthodox fiscal and monetary policies have to be used to stabilize such unstable macroeconomies.     

Real wages,real interest rates,and the Phillips curve

This article argues that any analysis of a Phillips curve should include the real interest rate in addition to inflation and real wages as any changes in the interest rate changes the labour–capital input mix in the production process leading to a change in the level of employment in the economy. To justify this argument a Phillips curve model is developed, which includes the real interest rate in addition to inflation and real wages. After the diagnosis of the time series properties of the data, an error correction model is developed and estimated using a set of US annual data from 1948 to 1996. The estimated parameters of the model do suggest that one should really take into consideration of the real interest rate while analysing the Phillips curve. A non-nested test (F-test) also suggests that the Phillips curve model with real interest rate as an additional variable performs better than the conventional method that does not include the real interest rate.     

On the constancy of real interest rates

In the context of a small structural model, we show that the autocorrelation and the variance of the ex ante real rate of interest can be uniquely estimated; the random forecasting errors need not confound the problem of identifying variations in the real rate.     

World real interest rates: a global savings and investment perspective

Over the past 15 years, long-term interest rates have declined to levels not seen since the 1970s. This article explores possible shifts in global savings and investment that have led to this fall in the world real interest rate. There are several key findings. First, the authors identify the relative weakness in investment demand as more important than the relative increase in desired global savings to explain the decline in global interest rates. Second, the results indicate that the key factors explaining movements in savings and investment are variables that evolve relatively slowly over time, such as labour force growth and age structure. The conclusions suggest that over the coming years, world real interest rates are likely to continue to adjust slowly, reflecting long-term trends.     

A cubic estimte of the term structure of interest rates for a money demand function

Heller and Khan (1979) estimate the term structure of interest rates by a quadratic equation in order to employ the estimated parameters of the term structure in a demand-for-money function. An important improvement of their estimates can be made by specifying a cubic rather than a quadratic equation in order to estimate “humped” term structures. Furthermore, the ordinal numbering of the maturities must be changed to the actual length of the maturity of each security to avoid estimation error.