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An Indicator of Future Inflation Extracted From the Steepness of the Interest Rate Yield Curve Along Its Entire Length

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  • Jeffrey A. Frankel
  • Cara S. Lown

Abstract

It is often suggested that the slope of the term structure of interest rates contains information about the expected future path of inflation. Mishkin (1990) has recently shown that the spread between the 12-month and 3-month interest rates helps to predict the difference between the 12-month and 3-month inflation rates. His approach however, lacks a theoretical foundation, other than the (rejected) hypothesis that the real interest rate is constant. This paper applies a simple existing theoretical framework, which allows the real interest rate to vary in the short run but converge to a constant in the long run, to the problem of predicting the inflation spread. It is shown that the appropriate indicator of expected inflation can make use of the entire length of the yield curve, in particular by estimating the steepness of a specific nonlinear transformation of the curve, rather than being restricted to a spread between two points. The resulting indicator, besides having a firmer theoretical foundation does a relatively good job of predicting the inflation rate over the period 1960 to 1988.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 3751.

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Date of creation: Jun 1991
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Publication status: published as Quarterly Journal of Economics, May 1994, pp. 517-530
Handle: RePEc:nbr:nberwo:3751

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  1. Kenneth A. Froot, 1987. "New Hope for the Expectations Hypothesis of the Term Structure of Interest Rates," NBER Working Papers 2363, National Bureau of Economic Research, Inc.
  2. 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.
  3. Mishkin, Frederic S., 1990. "Does correcting for heteroscedasticity help?," Economics Letters, Elsevier, vol. 34(4), pages 351-356, December.
  4. Philippe Jorion & Frederic Mishkin, 1991. "A Multi-Country Comparison of Term Structure Forecasts at Long Horizons," NBER Working Papers 3574, National Bureau of Economic Research, Inc.
  5. Frederic S. Mishkin, 1991. "A Multi-Country Study of the Information in the Term Structure about Future Inflation," NBER Working Papers 3125, National Bureau of Economic Research, Inc.
  6. Gikas A. Hardouvelis, 1987. "The predictive power of the term structure during recent monetary regimes," Research Paper 8708, Federal Reserve Bank of New York.
  7. Mishkin, Frederic S., 1990. "What does the term structure tell us about future inflation?," Journal of Monetary Economics, Elsevier, vol. 25(1), pages 77-95, January.
  8. Frederic S. Mishkin, 1988. "The Information in the Term Structure: Some Further Results," NBER Working Papers 2575, National Bureau of Economic Research, Inc.
  9. Robert J. Shiller & J. Huston McCulloch, 1987. "The Term Structure of Interest Rates," NBER Working Papers 2341, National Bureau of Economic Research, Inc.
  10. N. Gregory Mankiw & Lawrence H. Summers, 1987. "Do Long-Term Interest Rates Overreact to Short-Term Interest Rates?," NBER Working Papers 1345, National Bureau of Economic Research, Inc.
  11. Jeffrey A. Frankel, 1979. "A technique for extracting a measure of expected inflation from the interest rate term structure," International Finance Discussion Papers 148, Board of Governors of the Federal Reserve System (U.S.).
  12. Manuel H. Johnson, 1988. "Current Perspectives on Monetary Policy," Cato Journal, Cato Journal, Cato Institute, vol. 8(2), pages 253-260, Fall.
  13. 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.
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