The Term Structure of Interest Rates and Inflation Forecast Targeting

This paper examines the implications of the expectations theory of the term structure for the implementation of inflation targeting. We show that the responsiveness of the central bank's instrument to the underlying state of the economy is increasing in the duration of the long-term bond. On the other hand, an increase in duration will make long-term inflationary expectations and therefore also the long-term nominal interest rate less responsive to the state of the economy. The extent to which the central bank cares about output stabilization will exert a moderating influence on the central bank's response to the current indicators of future inflation. However, the effect of an increase in this parameter on the long-term nominal interest rate turns out to be ambiguous. Next, we show that both the sensitivity of the nominal term spread to economic fundamentals and the extent to which the spread predicts future output are increasing in the duration of the long bond and the degree of structural output persistence. However, if the central bank becomes relatively less concerned about inflation stabilization the term spread will be less successful in predicting real economic activity.