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Inflation, real short-term interest rates, and the term structure of interest rates: a regime-switching approach

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Abstract:

This study explores the implications of the expectations hypothesis by examining the implied term premium, in conjunction with an explicit description of processes generating both inflation and short-term real interest rates. It models inflation and short-term real interest rates using a technique that allows for changes in regimes and generates future forecasts of inflation and real interest rates. The hypothesis is that persistent shifts in the term premium under the expectations hypothesis might come from forecast errors by econometricians if regime shifts are omitted, shifts which are however observed by the agents. This study examines whether persistent shifts in the term premium can be eliminated after taking into account the regime shifts in the processes for inflation and real interest rates. The results indicate that there still exists persistence in the term premium. However the implied term premium generated from regime-switching models shows less persistence than those from ARIMA models. Although the regime-switching model does not reconcile the data with the expectations hypothesis, the results suggest that the persistence of the term premium obtained from a fixed-coefficient ARIMA model may be due in part to systematic forecast errors that are eliminated by allowing for regime changes.

Document Type: Research Article

DOI: http://dx.doi.org/10.1080/00036840122884

Publication date: February 1, 2001

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