Working Paper: CEPR ID: DP2375
Authors: Sylvester Eijffinger; Eric Schaling; Willem Verhagen
Abstract: 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.
Keywords: term structure of interest rates; inflation targets
JEL Codes: E43; E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increase in duration of long-term bonds (E43) | central bank's interest rate instrument responds more strongly to economic state (E52) |
| increase in duration of long-term bonds (E43) | long-term inflationary expectations are less volatile (E31) |
| long-term inflationary expectations are less volatile (E31) | long-term nominal interest rate is less sensitive to immediate economic changes (E43) |
| greater weight on output stabilization (E63) | nominal interest rate responds less vigorously to inflation indicators (E43) |
| duration of long-term bonds (E43) | term spread's predictive power for future output increases (E27) |
| less concern about output stabilization (E63) | term spread's predictive power for future output decreases (E32) |