Short-term Real Interest Rate Research Articles

Real Term Structure Forecasts of Consumption Growth

This paper suggests an affine term structure model of real interest rates to predict changes in real consumption growth. The model is estimated, jointly, by real interest rates and consumption data, and it is found to be consistent with the consumption smoothing hypothesis. The paper shows that the real term structure is spanned by two common factors, which can be given the interpretation of the level and slope factors, respectively. The risks associated with these factors are priced in the market. Both of these factors can explain the information content of the short-term real interest rate and its term spread with longer term interest rate in forecasting future real consumption growth, over different periods ahead.

Estimating Parameters of Short-Term Real Interest Rate Models

This paper sheds light on a narrow but crucial question in finance: What should be the parameters of a model of the short-term real interest rate? Although models for the nominal interest rate are well studied and estimated, dynamics of the real interest rate are rarely explored. Simple ad hoc processes for the short-term real interest rate are usually assumed as building blocks for more sophisticated models. In this paper, parameters of the real interest rate model are estimated in the broad class of single-factor interest rate diffusion processes on U.S. monthly data. It is shown that the elasticity of interest rate volatility—the relationship between the volatility of changes in the interest rate and its level—plays a crucial role in explaining real interest rate dynamics. The empirical estimates of the elasticity of the real interest rate volatility are found to be about 0.5, much lower than that of the nominal interest rate. These estimates show that the square root process, as in the Cox-Ingersoll-Ross model, provides a good characterization of the short-term real interest rate process.

Estimating Parameters of Short-Term Real Interest Rate Models

This paper sheds light on a narrow but crucial question in finance: What should be the parameters of a model of the short-term real interest rate? Although models for the nominal interest rate are well studied and estimated, dynamics of the real interest rate are rarely explored. Simple ad hoc processes for the short-term real interest rate are usually assumed as building blocks for more sophisticated models. In this paper, parameters of the real interest rate model are estimated in the broad class of single-factor interest rate diffusion processes on U.S. monthly data. It is shown that the elasticity of interest rate volatility — the relationship between the volatility of changes in the interest rate and its level — plays a crucial role in explaining real interest rate dynamics. The empirical estimates of the elasticity of the real interest rate volatility are found to be about 0.5, much lower than that of the nominal interest rate. These estimates show that the square root process, as in the Cox-Ingersoll-Ross model, provides a good characterization of the short-term real interest rate process.

Asset Allocation and Monetary Policy: Evidence from the Eurozone

The eurozone has a single short-term nominal interest rate, but monetary policy conditions measured by either real short-term interest rates or Taylor rule residuals varied substantially across countries in the period between 2003-2010. We use this cross-country variation in the (local) tightness of monetary policy conditions to examine its influence on equity and money market flows. In line with a powerful risk-shifting channel, we find that fund investors in countries with lower real interest rates shift their portfolio investment out of the money market and into the riskier equity market. This produces the strongest equity price increase in countries where domestic institutional investors hold a large share of the countries' stock market capitalization.

Asset Allocation and Monetary Policy: Evidence from the Eurozone

The eurozone has a single short-term nominal interest rate, but monetary policy conditions measured by real short-term interest rates varied substantially across countries in the period 2003-2010. We use this cross-country variation in the (local) tightness of monetary policy to examine its influence on equity and money market flows. In line with a powerful risk-shifting channel, we find that fund investors in countries with decreased real interest rates shift their portfolio investment out of the money market and into the riskier equity market causing significant equity price inflation in countries where investment home bias is the strongest.

Do oil prices respond to real interest rates?

We show that the robustness of an inverse relationship between the real interest rate and real oil price depends crucially on how the real interest rate is calculated, and the time-frame of the sample. Consistent with earlier studies, we find that the oil price falls with an unexpected rise in either U.S. or international ex-ante real interest rates. When the ex-post real interest rate is used, the oil price only falls with rises to short-term rates (3months or less). Additionally, the response of the oil price to long-term ex-ante real interest rates must include the period through the mid-2000s for the inverse relationship to appear. In contrast, the oil price consistently falls with unexpected rises in short-term real interest rates throughout the entire sample. We draw two conclusions from the results. The first is that the oil price is consistently responsive to short-term U.S. and international real interest rates, underlying the importance of storage. Second, oil prices have become more responsive to long-term real interest rates over time.

The Bank Lending Channel and Monetary Policy Rules for European Banks: Further Extensions

The monetary authorities affect the macroeconomic activity through various channels of influence. This paper examines the bank lending channel, which considers how central bank actions affect deposits, loan supply, and real spending. The monetary authorities influence deposits and loan supplies through its main indicator of policy, the real short-term interest rate. This paper employs the endogenously determined target interest rate emanating from the central bank’s monetary policy rule to examine the operation of the bank lending channel. Furthermore, it examines whether different bank-specific characteristics affect how European banks react to monetary shocks. That is, do sounder banks react more to the monetary policy rule than less-sound banks. In addition, inflation and output expectations alter the central bank’s decision for its target interest rate, which, in turn, affect the banking system’s deposits and loan supply. Robustness tests, using additional control variables, (i.e., the growth rate of consumption, the ratio loans to total deposits, and the growth rate of total deposits) support the previous results.

How Did the Financial Crisis Impact Retirees’ Safe Withdrawal Rate? A Markets-Based Answer

Individuals retiring in the aftermath of the financial crisis face an unprecedented market environment. Accommodative monetary policy and below trend economic growth present retirees with historically low interest rates and the longest period of negative real short term interest rates since the Great Depression. The result is likely a period of below-average, modest total portfolio returns that a particular challenge to retirees.Most studies of safe retirement withdrawal rates have concluded that a 4% initial withdrawal adjusted for inflation over subsequent years provides reasonable a reasonable margin of safety over thirty years. However, these studies are generally use historical analysis or forward-looking return analysis based on long-term return estimates and/or average realized returns. Because of this approach an extended period low nominal rates and negative real rates is not captured in traditional methodologies; therefore, they run the risk of overstating safe withdrawal rates.As an alternative, this article presents a market-based methodology for determining appropriate spending policy. Simulation analyses along with market-implied capital market assumptions (CMAs) are used to estimate feasible distribution rates for various portfolios over the next thirty years. The results imply that an initial withdrawal rate of 4% is unlikely to provide investors with a sufficient margin of safety. Instead, lowering initial withdrawal rates to 3.5% is likely to prove prudent.

The Bank Lending Channel and Monetary Policy Rules: Further Extensions

Many channels exist through which monetary policy decisions affect the economy. This paper examines the bank lending channel, which reflects the central bank's actions that affect loan supply and real spending. The main variable that affects loan supply is the monetary policy indicator as it is proxied by the real short-term interest rate. This paper examines how the bank lending channel operates when this short-term indicator is endogenously determined by the target rate the central bank sets through a monetary policy rule. Furthermore, it examines whether different bank-specific characteristics affect the way banks react to a monetary shock. We investigate the effect of such a rule on the bank lending channel in European banking institutions spanning 2000 through 2009. The expectations, concerning both inflation and output, affect the decision of the central bank for the target rate, which, in turn, affect the private sector's expectations -banks- by altering their loan supply.

The Bank Lending Channel and Monetary Policy Rules: Evidence from European Banks

There exist two main channels of the monetary transmission mechanism: the interest rate and the bank lending channel. This paper focuses on the latter, which is based on the central bank’s actions that affect loan supply and real spending. The supply of loans depends on the monetary policy indicator, which, in most studies, is the real short-term interest rate. The question investigated in this paper is how the operation of the bank lending channel changes when this short-term indicator is allowed to be endogenously determined by the target rate the central bank sets through a monetary rule. We examine the effect that a rule has on the bank lending channel in European banking institutions spanning the period 1999–2009. The expectations concerning inflation and output affect the decision of the central bank for the target rate, which, in turn, affect private sector’s expectations —commercial banks— by altering their loan supply.

Fiscal Policy and Interest Rates: The Role of Sovereign Default Risk

Recent events have highlighted the potential importance of nonlinear efiects of flscal variables (notably debt and deflcits) on interest rates: While in times when government solvency is not a concern the standard crowding-out efiects are of moderate magnitude, in times when default risk becomes an issue the interest rate efiects can become very large. This paper provides new evidence on the magnitude of these efiects. For the case when default risk is not a concern, it uses an arbitrage-free term structure model to estimate the dynamic efiects of flscal policy shocks on interest rates along the entire maturity spectrum. For the case when default risk becomes a concern (thereby violating a central assumption of the term structure model), I present evidence based on EMU government bond spread regressions on time-varying efiects of national flscal policies on spreads as well as the time-varying sensitivity of yield spreads to international risk aversion as a function of the state of flscal policy. JEL classiflcation: E6, H6.

The forecasting power of real interest rate gaps: an assessment for the Euro area

The real Interest Rate Gap (IRG)–the gap between the short-term real interest rate and its ‘natural’ level–is a theoretical concept that has attracted much attention in central banks in recent years. This article aims at clarifying its practical relevance for monetary policy in real time. For this purpose, it provides an empirical assessment of the usefulness of a semi-structural versus purely statistical estimates of the real IRG for predicting policy relevant macroeconomic variables in the Euro area. However mixed, the results confirm that semi-structural estimates of the real IRG deserve being added to the central banks’ toolbox.

Inflation Expectations, Real Rates, and Risk Premia: Evidence from Inflation Swaps

This paper develops a model of the term structures of nominal and real interest rates driven by state variables representing the short-term real interest rate, expected inflation, inflation’s central tendency, and four volatility factors that follow GARCH processes. We derive analytical solutions for nominal bond yields, yields on inflation-indexed bonds that have an indexation lag, and the term structure of expected inflation. Unlike prior studies, the model’s parameters are estimated using data on inflation swap rates, as well as nominal yields and survey forecasts of inflation. The volatility state variables fully determine bonds’ time-varying risk premia and allow for stochastic volatility and correlation between bond yields, yet they have small effects on the cross section of nominal yields. Allowing for time-varying volatility is particularly important for real interest rate and expected inflation processes, but long-horizon real and inflation risk premia are relatively stable. Comparing our model prices of inflation-indexed bonds to those of Treasury Inflation Protected Securities (TIPS) suggests that TIPS were significantly underpriced prior to 2004 and again during the 2008-2009 financial crisis.

Stochastic Volatility, Long Run Risks, and Aggregate Stock Market Fluctuations

What are the main drivers of ‡uctuations in the aggregate US stock market? In this paper, we attempt to resolve the long-lasting debate surrounding this question by designing and solving a consumption-based asset pricing model which incorporates stochastic volatility, long-run risks in consumption and dividends, and Epstein-Zin preferences. Utilizing Bayesian MCMC techniques, we estimate the model by …tting it to US data on the level of the aggregate US stock market, the short-term real risk-free interest rate, real consumption growth, and real dividend growth. Our results indicate that, over short and medium horizons, ‡uctuations in the level of the aggregate US stock market are mainly driven by changes in expected excess returns. Conversely, low frequency movements in the aggregate stock market are primarily driven by changes in the expected long-run growth rate of real dividends.

The Reliability of Macroeconomic Forecasts Based on Real Interest Rate Gap Estimates in Real Time: An Assessment for the Euro Area

The real interest rate gap -IRG-, i.e. the gap between the short term real interest rate and its “natural” level, is a theoretical concept of potential policy relevance for central banks, at least to evaluate the monetary policy stance, at best as a guideline for policy moves. This paper aims at clarifying the practical relevance of IRG indicators for monetary policy. To this end, it provides an empirical assessment of the usefulness of various univariate and multivariate estimates of the real IRG for predicting inflation, real activity and real credit growth in the euro area. On the basis of out-ofsample evidence using real-time data, I find that IRG measures are globally of little help to improve our knowledge of future inflation in the euro area. By contrast, some of the estimated IRG measures exhibit a significant predictive power for future real activity, in line with the intuition from a traditional IS curve, as well as for credit growth. Nevertheless, in most cases, the forecasting models that include estimated IRG do not outperform a simpler AR model augmented with the first difference of the nominal interest rate.

Test simultané de la non-stationnarité et de la non-linéarité : une application au taux d'intérêt réel américain

Dans cet article, nous analysons le taux d’intérêt réel à trois mois pour les Etats-Unis par l’intermédiaire d’une représentation M-SETAR ( Momentum - Self Exciting Threshold AutoRegressive ) sur les cinquante dernières années. Dans le but de distinguer la non linéarité de la non-stationnarité, nous utilisons des tests d’intégration à seuil contre une alternative stationnaire et non linéaire. Une innovation de ce travail réside dans l’introduction d’une rupture déterministe de telle sorte que le modèle autorise à la fois des changements de régime pour la partie déterministe (saut en niveau) et pour la partie stochastique (effets de seuil). L’exercice empirique porte sur l’écart entre le taux d’intérêt réel ex post et sa valeur naturelle qui change après la date de rupture. Nos résultats montrent que cet écart de taux réel suit un processus à seuil à deux régimes. En outre, le processus se comporte comme une martingale dans un des régimes, soulignant l’aspect “réactif” de la politique monétaire pour les périodes correspondantes.

Modelling money demand for a panel of eight transitional economies

In this article, we estimate money demand functions for a panel of eight transitional economies, using quarterly data for the period 1995:01 1995 to 2005:03. We find that real M1 and real M2 and their determinants, namely real income and short-term domestic interest rate, are cointegrated, both for individual countries as well as for the panel. Long-run elasticities suggest that consistent with theory, real income positively and nominal interest rate negatively impact real money demand. Our test for panel Granger causality suggests short-run bidirectional causality between M1 and M2 and their determinants. Finally, our tests for stability of the money demand functions reveal more cases of unstable money demand functions when M2 is used as a proxy for money demand.

AN INDICATOR OF MONETARY CONDITIONS FOR TURKEY

In this study, a Monetary Conditions Index (MCI) for Turkey is constructed for the 2003-2008 period, using a VAR methodology. The MCI weights are estimated on the basis of generalized accumulated responses of the inflation rate to one standard deviation shock to the real short term interest rate and the real rate of appreciation. The responses of output and inflation to interest rate and exchange rate shocks exhibit patterns which point to the structural peculiarities of the Turkish economy. The monetary conditions reflected by the resulting index are consistent with the path of inflation and CBT remarks on the issue.

Real Interest Rates and the Crisis: Where are the Rates Headed?

This paper examines the likely direction of real interest rates in the Euro area and the United States from April 2009 on. It is argued that the crisis that began in 2007 and the ensuing recession changed the descending trend in real interest rates which started a long time ago. If real interest rates were to rise too much, private and public finances, housing markets and stock markets would suffer particularly in the countries where the past credit binge and the crisis response has made debts mount, thus prolonging the current crisis. Economic theory should help shed light on the likely future direction of long-term real interest rates. In the paper, growth models are briefly discussed and shown to offer disparate predictions about the level of real interest rates in a growing economy and little practical guidance. Monetary theories, i.e. theories explicitly focused on the role of interest rates in balancing supply and demand in the single markets of the economy, make reference to some normal or natural level of real interest rate but obviously suffer from the difficulties of estimating such normal or natural levels both in general and particularly in a unusually dynamic and uncertain situation such as the current one. The more pragmatic approach, consisting in the assessment of the relevant single components of the long-term real nominal interest rate over the cycle, points to the risks of a surge in the risk premium as well as in expected short-term real interest rates and thus to a prolongation of the current economic contraction.

Understanding Inflation-Indexed Bond Markets

This paper explores the history of inflation-indexed bond markets in the US and the UK. It documents a massive decline in long-term real interest rates from the 1990's until 2008, followed by a sudden spike in these rates during the financial crisis of 2008. Break even inflation rates, calculated from inflation-indexed and nominal government bond yields, stabilized until the fall of 2008, when they showed dramatic declines. The paper asks to what extent short-term real interest rates, bond risks, and liquidity explain the trends before 2008 and the unusual developments in the fall of 2008. Low inflation-indexed yields and high short-term volatility of inflation-indexed bond returns do not invalidate the basic case for these bonds, that they provide a safe asset for long-term investors. Governments should expect inflation-indexed bonds to be a relatively cheap form of debt financing going forward, even though they have offered high returns over the past decade.