Core and 'Crust': Consumer Prices and the Term Structure of Interest Rates

50 Pages Posted: 29 May 2011 Last revised: 23 Dec 2012

Andrea Ajello

Federal Reserve Board

Luca Benzoni

Federal Reserve Bank of Chicago - Research Department

Olena Chyruk

Federal Reserve Bank of Chicago

Date Written: December 19, 2012

Abstract

We propose a no-arbitrage model that jointly explains the dynamics of consumer prices as well as the nominal and real term structures of risk-free rates. In our framework, distinct core, food, and energy price series combine into a measure of total inflation to price nominal Treasuries. This approach captures different frequencies in inflation fluctuations: Shocks to core are more persistent and less volatile than shocks to food and, especially, energy (the 'crust'). We find that a common structure of latent factors determines and predicts the term structure of yields and inflation. The model outperforms popular benchmarks and is at par with the Survey of Professional Forecasters in forecasting inflation. Real rates implied by our model uncover the presence of a time-varying component in TIPS yields that we attribute to disruptions in the inflation-indexed bond market. Finally, we find a pronounced declining pattern in the inflation risk premium that illustrates the changing nature of inflation risk in nominal Treasuries.

The appendices for this paper are available at the following URL: http://ssrn.com/abstract=2192271

Keywords: term structure of interest rates, real rates, inflation, inflation risk premium, real rate risk premium

JEL Classification: G12, E43, E44, E31, E37

Suggested Citation

Ajello, Andrea and Benzoni, Luca and Chyruk, Olena, Core and 'Crust': Consumer Prices and the Term Structure of Interest Rates (December 19, 2012). Available at SSRN: https://ssrn.com/abstract=1851906 or http://dx.doi.org/10.2139/ssrn.1851906

Andrea Ajello

Federal Reserve Board ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

HOME PAGE: http://sites.google.com/site/ajelloandrea/

Luca Benzoni (Contact Author)

Federal Reserve Bank of Chicago - Research Department ( email )

230 South LaSalle Street
Chicago, IL 60604
United States
312-322-8499 (Phone)

HOME PAGE: http://lbenzoni.frbchi.googlepages.com/

Olena Chyruk

Federal Reserve Bank of Chicago ( email )

230 South LaSalle Street
Chicago, IL 60604
United States

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