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Yield curve forecasts of inflation: a cautionary tale

  • Stephen R. Blough
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    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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    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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    1. McCulloch, J Huston, 1975. "The Tax-Adjusted Yield Curve," Journal of Finance, American Finance Association, vol. 30(3), pages 811-30, June.
    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. Newey, Whitney K & West, Kenneth D, 1987. "A Simple, Positive Semi-definite, Heteroskedasticity and Autocorrelation Consistent Covariance Matrix," Econometrica, Econometric Society, vol. 55(3), pages 703-08, May.
    4. 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.
    5. 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.
    6. 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.
    7. repec:tpr:qjecon:v:101:y:1986:i:2:p:211-28 is not listed on IDEAS
    8. Frederic S. Mishkin, 1989. "The Information in the Longer Maturity Term Structure about Future Inflation," NBER Working Papers 3126, National Bureau of Economic Research, Inc.
    9. Engle, Robert F & Ng, Victor K, 1993. "Time-Varying Volatility and the Dynamic Behavior of the Term Structure," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 25(3), pages 336-49, August.
    10. 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.
    11. 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.
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