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Yield curve forecasts of inflation: a cautionary tale

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  • Stephen R. Blough
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    Abstract

    Long-term interest rates that are unusually high relative to shortterm interest rates are often seen to reflect market expectations of increasing inflation. Given that the term structure of interest rates (also called the yield curve) reacts to inflation expectations, does it do so in a reasonable manner? Does the term structure embody inflation forecasts that bear a sensible relationship to the iiaflation that in fact occurs? ; This article reviews the theoretical link between the term structure and inflation expectations, and then it provides empirical evidence on the link in light of the theory. It finds little evidence of a link between the term structure and future inflation at the horizon chosen for study, the relationship between one- and two-year interest rates and the one-year ahead change in the one-year inflation.

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    File URL: http://www.bostonfed.org/economic/neer/neer1994/neer394a.pdf
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    Bibliographic Info

    Article provided by Federal Reserve Bank of Boston in its journal New England Economic Review.

    Volume (Year): (1994)
    Issue (Month): May ()
    Pages: 3-16

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    Handle: RePEc:fip:fedbne:y:1994:i:may:p:3-16

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    Keywords: Inflation (Finance) ; Interest rates;

    References

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    1. N. Gregory Mankiw & Jeffrey A. Miron, 1985. "The Changing Behavior of the Term Structure of Interest Rates," NBER Working Papers 1669, National Bureau of Economic Research, Inc.
    2. Stephen G. Cecchetti, 1987. "The Case of the Negative Nominal Interest Rates: New Estimates of the Term Structure of Interest Rates During the Great Depression," NBER Working Papers 2472, National Bureau of Economic Research, Inc.
    3. Richardson, Matthew & Stock, James H., 1989. "Drawing inferences from statistics based on multiyear asset returns," Journal of Financial Economics, Elsevier, vol. 25(2), pages 323-348, December.
    4. Frederic S. Mishkin, 1991. "The Information in the Longer Maturity Term Structure about Future Inflation," NBER Working Papers 3126, National Bureau of Economic Research, Inc.
    5. McCulloch, J Huston, 1975. "The Tax-Adjusted Yield Curve," Journal of Finance, American Finance Association, vol. 30(3), pages 811-30, June.
    6. Froot, Kenneth A, 1989. " New Hope for the Expectations Hypothesis of the Term Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 44(2), pages 283-305, June.
    7. Newey, Whitney & West, Kenneth, 2014. "A simple, positive semi-definite, heteroscedasticity and autocorrelation consistent covariance matrix," Applied Econometrics, Publishing House "SINERGIA PRESS", vol. 33(1), pages 125-132.
    8. Robert F. Engle & Victor K. Ng, 1991. "Time-Varying Volatility and the Dynamic Behavior of the Term Structure," NBER Working Papers 3682, National Bureau of Economic Research, Inc.
    9. Fama, Eugene F., 1990. "Term-structure forecasts of interest rates, inflation and real returns," Journal of Monetary Economics, Elsevier, vol. 25(1), pages 59-76, January.
    10. Baum, Christopher F & Thies, Clifford F, 1992. "On the Construction of Monthly Term Structures of U.S. Interest Rates, 1919-1930," Computer Science in Economics & Management, Society for Computational Economics, vol. 5(3), pages 221-46, August.
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    Cited by:
    1. Yash P. Mehra, 1997. "The bond rate and actual future inflation," Working Paper 97-03, Federal Reserve Bank of Richmond.
    2. Ravenna , Federico & Seppälä , Juha, 2006. "Monetary policy and rejections of the expectations hypothesis," Research Discussion Papers 25/2006, Bank of Finland.
    3. Sharon Kozicki, 2001. "Why do central banks monitor so many inflation indicators?," Economic Review, Federal Reserve Bank of Kansas City, issue Q III, pages 5-42.
    4. Christopher Ragan, 1995. "Deriving Agents' Inflation Forecasts from the Term Structure of Interest Rates," Macroeconomics 9502003, EconWPA.
    5. Rudebusch, Glenn D., 1995. "Federal Reserve interest rate targeting, rational expectations, and the term structure," Journal of Monetary Economics, Elsevier, vol. 35(2), pages 245-274, April.
    6. Crockett, Jean A., 1998. "Rational expectations, inflation and the nominal interest rate," Journal of Econometrics, Elsevier, vol. 83(1-2), pages 349-363.
    7. Seppala, Juha, 2004. "The term structure of real interest rates: theory and evidence from UK index-linked bonds," Journal of Monetary Economics, Elsevier, vol. 51(7), pages 1509-1549, October.

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