The influence of real interest rates and risk premium effects on the ability of the nominal term structure to forecast inflation

Abstract

Based on an empirically attractive Gaussian dynamic term structure model and data on the short-term real interest rate and per capita real consumption, this paper examines the information content of the nominal term structure of interest rates with respect to inflation, real interest rates and risk premium effects. The paper finds a number of interesting results, which have monetary policy implications. First, it shows that the suggested model fits well the data and provides estimates of real interest rates and expected inflation rates which are very close to those given by survey data. Second, it provides clear cut evidence that the nominal term structure is mainly determined by movements in real interest rates and, to a lesser extent, by inflation and risk premium effects. These results mean that term spreads between long and short-term nominal rates fail to forecast future changes in inflation rates because are dominated by real term structure effects, which are not orthogonal to inflation rate shocks (changes). Third, to retrieve information from the term spread models of nominal interest rates about future inflation rate changes, the paper suggests a regression model which adjusts the nominal interest rates term spreads for the real term structure effects.