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

  • Jeffrey A. Frankel
  • Cara S. Lown

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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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
Date of revision:
Publication status: published as Quarterly Journal of Economics, May 1994, pp. 517-530
Handle: RePEc:nbr:nberwo:3751
Note: ME
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  1. Gikas A. Hardouvelis, 1987. "The predictive power of the term structure during recent monetary regimes," Research Paper 8708, Federal Reserve Bank of New York.
  2. Mishkin, Frederic S., 1990. "Does correcting for heteroscedasticity help?," Economics Letters, Elsevier, vol. 34(4), pages 351-356, December.
  3. 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.
  4. Frederic S. Mishkin, 1988. "What Does the Term Structure Tell Us About Future Inflation?," NBER Working Papers 2626, 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. Frankel, Jeffrey A, 1982. "A Technique for Extracting a Measure of Expected Inflation from the Interest Rate Term Structure," The Review of Economics and Statistics, MIT Press, vol. 64(1), pages 135-42, February.
  7. Jorion, Philippe & Mishkin, Frederic, 1991. "A multicountry comparison of term-structure forecasts at long horizons," Journal of Financial Economics, Elsevier, vol. 29(1), pages 59-80, March.
  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. 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.
  10. Manuel H. Johnson, 1988. "Current Perspectives on Monetary Policy," Cato Journal, Cato Journal, Cato Institute, vol. 8(2), pages 253-260, Fall.
  11. N. Gregory Mankiw & Lawrence H. Summers, 1984. "Do Long-Term Interest Rates Overreact to Short-Term Interest Rates?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 15(1), pages 223-248.
  12. 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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