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The Term Structure of Real Rates and Expected Inflation

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Ang, Andrew
Bekaert, Geert

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Abstract

Changes in nominal interest rates must be due to either movements in real interest rates, expected inflation, or the inflation risk premium. We develop a term structure model with regime switches, time-varying prices of risk and inflation to identify these components of the nominal yield curve. We find that the unconditional real rate curve is fairly flat at 1.44%, but slightly humped. In one regime, the real term structure is steeply downward sloping. Real rates (nominal rates) are pro-cyclical (counter-cyclical) and inflation is negatively correlated with real rates. An inflation risk premium that increases with the horizon fully accounts for the generally upward sloping nominal term structure. We find that expected inflation drives about 80% of the variation of nominal yields at both short and long maturities, but during normal times, all of the variation of nominal term spreads is due to expected inflation and inflation risk.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4518.

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Date of creation: Aug 2004
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Reschreiter, Andreas, 2006. "Indexed Bonds and Revisions of Inflation Expectations," Economics Series 199, Institute for Advanced Studies. [Downloadable!]
  2. Lieven Baele & Geert Bekaert & Koen Inghelbrecht, 2007. "The determinants of stock and bond return comovements," Research series 200711-27, National Bank of Belgium. [Downloadable!]
  3. Ravenna , Federico & Seppälä, Juha, 2007. "Monetary policy, expected inflation and inflation risk premia," Research Discussion Papers 18/2007, Bank of Finland. [Downloadable!]
  4. Peter Vlaar, 2007. "Term Structure Modeling for Pension Funds:What to do in Practice?," DNB Working Papers 123, Netherlands Central Bank, Research Department. [Downloadable!]
  5. David K. Backus & Jonathan H. Wright, 2007. "Cracking the Conundrum," Working Papers 07-22, New York University, Leonard N. Stern School of Business, Department of Economics. [Downloadable!]
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  6. Adrien Verdelhan, 2006. "A Habit-Based Explanation of the Exchange Rate Risk Premium," Boston University - Department of Economics - Macroeconomics Working Papers Series WP2006-047, Boston University - Department of Economics. [Downloadable!]
  7. Beechey, Meredith, 2004. "Excess Sensitivity and Volatility of Long Interest Rates: The Role of Limited Information in Bond Markets," Working Paper Series 173, Sveriges Riksbank (Central Bank of Sweden). [Downloadable!]
  8. Andrew Ang & Sen Dong & Monika Piazzesi, 2005. "No-arbitrage Taylor rules," Proceedings, Federal Reserve Bank of San Francisco. [Downloadable!]
    Other versions:
  9. Hasseltoft, Henrik, 2007. "The Long-run Risk Model: Dynamics and Cyclicality of Interest Rates," SIFR Research Report Series 58, Swedish Institute for Financial Research. [Downloadable!]
  10. Peter Spreij & Enno Veerman & Peter Vlaar, 2008. "Multivariate Feller conditions in term structure models: Why do(n't) we care?," DNB Working Papers 173, Netherlands Central Bank, Research Department. [Downloadable!]
  11. Georges Dionne & Geneviève Gauthier & Khemais Hammami & Mathieu Maurice & Jean-Guy Simonato, 2007. "A Reduced Form Model of Default Spreads with Markov Switching Macroeconomic Factors," Cahiers de recherche 0741, CIRPEE. [Downloadable!]
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