Long-Term Interest Rates and Inflation
University of Piraeus Department of Banking and Finance Working Paper
43 Pages Posted: 23 Jun 2003
Date Written: February 2003
In this paper we analyse the relationship between long bond yields and inflation in an economy subject to three types of stochastic disturbances: real shocks, nominal shocks, and shocks to term premia. Statistical inference is based on the impulse-response function of a Structural VAR model, where appropriate long-run identifying restrictions are derived from economic theory. Using data for the U.S. over the past 45 years, we find that long bond yields and inflation move one-for-one both in the medium term and in the long term when the economy is subject to real or nominal shocks. However, the predictive power of long bond yields for future inflation breaks down when bond yields are driven by changes in term premia. Given that term premia are related to interest rate volatility, our results help explain the negative correlation between long bond yields and inflation during the 1980s, when interest rate volatility climbed to historical peaks.
Keywords: Fisher Effect, VAR, Expectations Hypothesis, Consumption CAPM
JEL Classification: E43, E44
Suggested Citation: Suggested Citation