Testing for Unbiasedness of Term Structure and Interest Differentials As Predictors of Future Inflation Changes and Inflation Differentials

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This paper argues that the unbiasedness of interest differentials as predictors of future inflation differentials and of the term structure as a predictor of future inflation changes are independent propositions. The first requires rational expectations (RE) and equality of ex-ante real interest rates, which holds only in the presence of uncovered interest parity (UIP) and ex-ante purchasing power parity (PPP). The second is correct if, in addition to RE, the Fisher hypothesis and co:nstancy of ex-ante real rates are satisfied. The issue of the information contained in the term structure of interest rates is important because if the relationship between interest rates for different maturities could help predict future inflation the yield curve could be a guide for monetary policy. Fama's (1975) seminal paper found that real interest rates are constant over time, with fluctuations in nominal rates mainly reflecting changes in expected inflation (the so-called Fisher effect). On the contrary, Mishkin (1984a) rejected the constancy of real rates and the existence of a Fisher effect in a number of OECD countries. As for the hypothesis that interest differentials are unbiased predictors of future inflation differentials, it is of interest for two main reasons. First, the equality of real rates which is implied would mean that monetary policy is not an effective stabilization tool in an open economy as real economic activity could not be influenced through the real interest rate. Second, real interest rate equalization across countries requires that UIP and PPP be satisfied. Therefore it is a test of the monetary approach to exchange rates versus models which depend on real rates differing between countries in the short run. Amongst previous researchers, Mishkin (1984b) could not reject the equality hypothesis in bilateral tests of the US vis-a-vis six industrialized