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.     

Nonstationarity,cointegration and structural breaks in the Australian term structure of interest rates

This article examines the unit-root property of the Australian short- and long-term interest rates using unit-root tests that accommodate a single or two breaks under the null and/or alternative hypothesis. Two breaks in interest rates are found to coincide with the 1982/83 and 1990/91 recessions or the 1993 inflation targeting period. We further investigate the implications of these structural breaks on the cointegrating relationship implied by the single, linear expectations hypothesis of the term structure of interest rates. While there is evidence that the data are consistent with the expectations hypothesis at the shorter end of the term structure, breaks in interest rates generate a shift in the cointegrating relationship, thus altering the information content of the term structure. Failing to account for a regime shift in the cointegration regression, the data erroneously supports the expectations hypothesis at the longer end of the term structure. These results have profound implications for policy makers who may inadequately exploit the information content of the term structure to predict future changes in inflation.     

Markov-switching models,rational expectations and the term structure of interest rates

In order to evaluate the efficiency of the monetary transmission mechanism, we develop the formulas for testing rational expectations theory in the term structure of interest rates with VAR models of stochastically switching regimes in which all the parameters are regime dependent. These formulas are obtained for the strict version of rational expectations as well as for the case where measurement errors are assumed in the expectations relationship. They are extensible to other contexts that involve variables linked by rational-expectations behaviours. The testing procedure is implemented on interest rates of the Spanish inter-bank money market. Measurement errors must be assumed to find signs favourable to the theory.     

The expectations theory of the term structure: Evidence from inflation forecasts

This paper tests the joint hypothesis of rational expectations and the expectations theory of the term structure using the Livingston survey data on price inflation forecasts. For a variety of sample periods, the paper presents evidence that the data are consistent with the theory. Since inflation forecasts, unlike interest rates, are not linked to specific underlying financial assets, the relationship between longterm and short-term inflation forecasts should not embody risk premia. This paper's findings therefore lend support to the view that a time-varying risk premium is needed to explain the observed term structure of interest rates.     

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).     

A dynamic Nelson-Siegel yield curve model with Markov switching

This paper proposes a model to better capture persistent regime changes in the interest rates of the US term structure. While the previous literature on this matter proposes that regime changes in the term structure are due to persistent changes in the conditional mean and volatility of interest rates we find that changes in a single parameter that determines the factor loadings of the model better captures regime changes. We show that this model gives superior in-sample forecasting performance as compared to a baseline model and a volatility-switching model. In general, we find compelling evidence that the extracted factors from our term structure models are closely related with various economic variables. Furthermore, we investigate and find evidence that the effects of macroeconomic phenomena such as monetary policy, inflation expectations, and real economic activity differ according to the particular regime realized for the term structure. In particular, we identify the periods where monetary policy appears to have a greater effect on the yield curve, and the periods where inflation expectations seem to have a greater effect in yield determination. We also find convincing evidence of a relationship between the regimes estimated by the various switching models with economic activity and monetary policy.     

Real and nominal UK interest rates,ERM membership,and inflation targeting

This article estimates a two-factor term structure model to analyze the time-varying mean-reverting levels of the UK real and nominal short-term interest rates. Before and during British membership in the ERM, the mean-reverting levels of real and nominal short rates have a strong negative correlation. Afterward, when the UK implemented an inflation targeting policy, the mean-reverting levels have a strong positive correlation. The article also reports empirical evidence of a link between the time-varying central tendencies and inflation in the disinflation period before the implementation of the inflation targeting policy.     

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.     

Real interest rates,inflation and the open economy: A regime-switching perspective on Australia and New Zealand

We investigate the time-series properties of Australian and New Zealand real interest rates within a Markov-switching framework. This enables us to identify characteristics in real interest rate behavior hitherto unacknowledged. We find that rates switch between alternative stationary regimes characterized by differing means, speeds of mean-reversion and volatility. For New Zealand, high rates of inflation increase the probability of remaining in a regime characterized by a faster speed of adjustment. Further application of this methodology considers the real interest rate differential between Australia and New Zealand and points to differing regimes based on volatility rather than persistence.     

The effects of the monetary policy regime shift to inflation targeting on the real interest rate in the United Kingdom

This paper studies the effects of the monetary policy regime shift to inflation targeting on the stochastic properties of the real interest rate in the U.K. The empirical analysis suggests a constant mean of the real interest rate that shifts with the monetary policy regime change to inflation targeting in October 1992. The mean-reverting level of the real interest rate has decreased from 5.1% to 2.3% per annum with the change in monetary policy to inflation targeting. In addition, the shift in monetary policy regime to inflation targeting has reduced the volatility of the real interest rate and increased the persistence of real interest rate deviations from the mean. The results suggest that the central bank can affect the stochastic properties of the real interest rate through the choice of monetary policy regime over a long period of time.     

Inventory accumulation and expectations of real income,inflation and interest rates

A model is developed and tested to relate three categories of inventory accumulation to expectations of real income, inflation and interest rates through anticipated real corporate wealth effects. Expected future inflation leads firms to accumulate more inventories in advance financing them by means of ‘liquid’ assets to offset an anticipated loss of real wealth. Expected increases in interest rates have an impact on inventory accumulation opposite to that of expected future inflation. Past wealth effects are also allowed for by means of the accelerator principle. Finally, the growth rate of real income generally has a signifiant influence on inventory accumulation.     

Cross-Country Evidence on the Ability of the Nominal Interest Rate to Predict Inflation

This paper examines the viability of using short-term interest rates to forecast inflation as implied by the Fisher hypothesis. A major problem with this approach lies in the implicit assumptions that the real interest rate is constant and that the relationship between inflation and interest rate does not change over time. We demonstrate, using quarterly data for four OECD countries, that by relaxing these assumptions and allowing for seasonality in the inflation rate it is possible to obtain a model with a high degree of forecasting accuracy and efficiency.
JEL Classification Numbers: C22, C52, E31.     

Money, expectations, and interest rates

This paper employs a model of nominal interest rate determination in a framework of rational expectations of inflation. Hypotheses are developed with respect to relative impacts of predictable and unpredictable changes in money supply. These hypotheses are tested using quarterly Italian data from 1966–1975. The nominal monetary base is the measure of money employed and one private and two government bond rates measure nominal interest rates. The results are insensitive to variations in estimation procedure and specification of adjustment processes (and even predictive functions for the monetary base). The rational expectations formulation is well supported in every case.     

Risk and Policy Shocks on the US Term Structure

We document two stylized facts of US short‐term and long‐term interest rate data seemingly incompatible with the expectations hypothesis: low contemporaneous cross‐correlation and relatively slow adjustment to long‐run relationships. We explain these features in a small structural model with three types of randomness: While a persistent monetary policy shock implies immediate identical reactions through the term structure, both a transitory policy shock and an autocorrelated risk premium allow for sustained deviations. Indeed, we find important impacts and persistence of risk premia and considerable contribution of transitory policy shocks to short rates. Results of standard expectations hypothesis tests can be rationalized.     

Comparative accuracy of forecasts of inflation: a Canadian study

An inaccurate forecast of inflation is costlier to economic agents when the inflation rate is high and volatile. In this situation, the use of more sophisticated and information-oriented forecasting models become economically efficient. We test this hypothesis by analysing the forecasting accuracy of vector auto-regressive (VAR), auto-regressive integrated moving average (ARIMA) and static expectation models. We use Canadian data and divide the post-sample forecasting period into four sub-periods, based on high/low and volatile/stable inflation. Prediction errors are compared for both short-term and long-term forecasts. Finally, the paper proposes a portfolio approach for obtaining a more accurate forecast of inflation.     

Competing macro-hypotheses in the United States: A Kalman filtering approach

The empirical validity of alternative views about the short-run determinants of real output growth in the United States is investigated. A nested framework is used to test the macro rational expectations (MRE) hypothesis directly against two competing hypotheses - the neo-Keynesian view that anticipated and unanticpated monetary policy both matter,and Friedman's (1977) proposition that increased inflation uncertainty reduces real output at least temporarily. The unobservable explanatory variables are obtained from time-varying-parameter models of inflation and money growth, which generate forecast errors and their conditional variances consistent with rational expectations under a continuously chaning policy regime. The empirical results strongly support Friedman's view. The MRE hypothesis must be rejected since both anticipated and unanticipated monetary changes matter. The results prove robust across different model specifications and estimation techniques.     

Monetary policy and long-term US interest rates

This paper assesses the effect of federal funds rate innovations on longer-term US nominal interest rates across different periods. The evidence suggests that these responses change with changes in the monetary policy regime. Time periods considered are pre- and post-1979 and different Federal Reserve Chairman’s tenure. The response of longer-term interest rates to federal funds rate innovations are shown to be smaller and less persistent in the post-1979 period when the Federal Reserve placed more emphasis on inflation.     

Labour markets, liquidity, and monetary policy regimes

Abstract.  We develop an equilibrium model of the monetary policy transmission mechanism that highlights information frictions in the market for money and search frictions in the labour market. The information friction increases the persistence in the response of interest rates following monetary policy regime shifts. This occurs because agents have incomplete information about the nature of the shifts and optimally update their inflation forecasts using an 'adaptive' expectations rule. The search friction transmits the interest rate movements to the labour market by affecting job creation activities; together, the two frictions imply that unemployment reacts very gradually to monetary policy shocks. JEL Classification: E4, E5     

Term Spreads,Forward Rates and Yield Curve Forecasts

The expectations hypothesis contends that long rates should equal expected forthcoming average short rates. The spread between long and short rates should therefore forecast changes in short rates. In addition, forward rates should anticipate future spot rates. We present econometric evidence for the Euro area in the period from September 2004 to August 2018. In our sample, term spreads are negatively correlated to subsequent interest rate changes. The difference between forward and spot rates is conversely positively correlated to ensuing spot rate changes. Further regression analysis shows, that nominal interest rates do not have predictive properties for future inflation. A vector autoregression analysis whilst revealing medium term overconfidence of Euro area investors, suggests that the propositions of the expectations hypothesis should hold over relatively long periods of time.     

Unit roots,interest rate spreads,and inflation forecasts

Recent research suggests that long-term interest rate spreads provide information that can be useful in forecasting inflation, but that the spread between the three-month and six-month Treasury bill rates appears to have little forecasting ability. This paper uses the concepts of unit roots and cointegration to examine the failure of the short-term T-bill spread to forecast inflation. The results suggest that the interest rate spread has little forecasting value because inflation and the interest rate spread exhibit distinctly different time-series properties.