Working Paper: CEPR ID: DP4518
Authors: Andrew Ang; Geert Bekaert
Abstract: Changes in nominal interest rates must be due to either movements in real interest rates, expected inflation, or the inflation risk premium. We develop a term structure model with regime switches, time-varying prices of risk and inflation to identify these components of the nominal yield curve. We find that the unconditional real rate curve is fairly flat at 1.44%, but slightly humped. In one regime, the real term structure is steeply downward sloping. Real rates (nominal rates) are pro-cyclical (counter-cyclical) and inflation is negatively correlated with real rates. An inflation risk premium that increases with the horizon fully accounts for the generally upward sloping nominal term structure. We find that expected inflation drives about 80% of the variation of nominal yields at both short and long maturities, but during normal times, all of the variation of nominal term spreads is due to expected inflation and inflation risk.
Keywords: term structure; real rates; expected inflation; inflation risk premium
JEL Codes: E43; E44
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| regime (P26) | shape of the real rate curve (E43) |
| inflation (E31) | real rates (E43) |
| expected inflation (E31) | nominal yields (G12) |
| inflation risk premium (E31) | nominal yield structure (E43) |
| real rates (E43) | economy (O51) |