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Non-Markov Gaussian Term Structure Models: The Case of Inflation

Bruno Feunou

Bank of Canada

Jean-Sebastien Fontaine

Bank of Canada

March 1, 2014

Forthcoming in the Review of Finance

Standard Gaussian macro-finance term structure models impose the Markov property: the conditional mean is a function of the risk factors. We relax this assumption parsimoniously, and consider models where yields are linear in the conditional mean (but not in the risk factors). To illustrate, if inflation is one of the factors, then yields should span expected inflation but not inflation. We confirm that model forecasts match the out-of-sample accuracy of survey forecasts. Second, expected and surprise yield changes can have opposite contemporaneous effects on expected inflation. We confirm the difference empirically. Third, the inflation survey forecasts and the inflation rate can be used consistently within the state equation. These three features are inconsistent with the Markov assumption. Our results hold for the US and for Canada, and the decomposition of nominal yields differs from that of the standard specification.

Number of Pages in PDF File: 56

Keywords: Markov, Term Structure, Inflation Risk Premium, Real Yields, Inflation Forecasts, Survey of Professional Forecasters

JEL Classification: E43, E47, G12

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Date posted: October 16, 2012 ; Last revised: April 3, 2014

Suggested Citation

Feunou, Bruno and Fontaine, Jean-Sebastien, Non-Markov Gaussian Term Structure Models: The Case of Inflation (March 1, 2014). Forthcoming in the Review of Finance. Available at SSRN: https://ssrn.com/abstract=2162168 or http://dx.doi.org/10.2139/ssrn.2162168

Contact Information

Bruno Feunou
Bank of Canada ( email )
234 Wellington Street
Ottawa, Ontario K1A 0G9
613-782-8302 (Phone)
613-782-7713 (Fax)
HOME PAGE: http://kamkui.net/
Jean-Sebastien Fontaine (Contact Author)
Bank of Canada ( email )
234 Wellington Street
Ontario, Ottawa K1A 0G9
HOME PAGE: http://www.jean-sebastienfontaine.com
Feedback to SSRN

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