How Strong is the Relation between the Term Structure, Inflation and GDP?
49 Pages Posted: 3 Jun 2001
Date Written: March 2001
This paper develops and estimates an equilibrium model which investigates the relationship between the term structure of interest rates, inflation and GDP growth. The model accounts for non-neutral effects of inflation, so that real and monetary variables are interrelated and jointly influence the term structure of interest rates, while bond yields convey information about expectations of output growth and inflation. Estimation is based on quarterly data for the United States over the period 1960-1999 and is carried out using a maximum likelihood - Kalman filter approach. The model fits the nominal term structure well and provides estimates for the implicit real term structure and for other unobservable variables, such as the instantaneous real interest rate and expected inflation rate and their time-varying central tendencies. The latter variables are shown to be strictly related to market expectations of medium-long term interest rate targets of the monetary authority. The estimates show that the covariance between output growth and inflation significantly affects long-term nominal bond prices, whereas the cross-sectional restrictions which link the yield curve to the macroeconomic variables give rise to relatively accurate in-sample and out-of-sample forecasts of inflation and GDP growth. The model also produces satisfactory predictions for future movements of the slope of the yield curve.
Keywords: Term structure of interest rates, inflation, economic growth, Kalman filter
JEL Classification: E31, E32, E43, E44, G12
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