A Prism Decomposition Of Euro Area Interest Rates

This article presents the Primary Rate-of-Interest Structural Model (PRISM), a new affine term structure model with flexible representations as a 3-, 6- and 9-factor model, depending on the desired level of analysis. PRISM offers an integrated view of interest rates that unifies term premia, inflation and credit risk considerations. It can be employed to decompose bond yields into nominal and real expected short-term rates and term premia, as well as expected inflation, inflation risk and credit risk subcomponents. Model results are illustrated with an application to benchmark interest rates, inflation swaps, CDS curves and the sovereign yields of the ten largest euro area economies. Besides providing a trajectory for short-term rates and the term premium, PRISM can track developments in other key macrofinancial variables such as the natural interest rate, the stance of conventional monetary policy, the degree of anchoring of long-term inflation expectations, the direction of inflation risks and the contribution of credit risk to sovereign yields via the short-term rate and the term premium subcomponents.