The Term Structure of Real Rates and Expected Inflation

64 Pages Posted: 16 Jul 2003

See all articles by Geert Bekaert

Geert Bekaert

Columbia Business School - Finance and Economics

Andrew Ang

BlackRock, Inc

Multiple version iconThere are 3 versions of this paper

Date Written: March 15, 2004

Abstract

Changes in nominal interest rates must be due to either movements in real interest rates or expected inflation, or both. We develop a term structure model with regime switches, time-varying prices of risk and inflation to identify these components of the nominal yield curve. We find that the unconditional real rate curve is fairly flat at 1.44%, but slightly humped. In one regime, the real term structure is steeply downward sloping. Real rates (nominal rates) are pro-cyclical (counter-cyclical) and inflation is negatively correlated with real rates. An inflation risk premium that increases with the horizon fully accounts for the generally upward sloping nominal term structure. We find that expected inflation drives about 80% of the variation of nominal yields at both short and long maturities, but during normal times, all of the variation of nominal term spreads is due to expected inflation and inflation risk.

Keywords: regime-switching term structure model, inflation risk premium, business cycles

JEL Classification: C50, E31, E32, E43, E44, G12

Suggested Citation

Bekaert, Geert and Ang, Andrew, The Term Structure of Real Rates and Expected Inflation (March 15, 2004). EFA 2004 Maastricht Meetings Paper No. 1220; AFA 2004 San Diego Meetings. Available at SSRN: https://ssrn.com/abstract=415060 or http://dx.doi.org/10.2139/ssrn.415060

Geert Bekaert

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

Andrew Ang (Contact Author)

BlackRock, Inc ( email )

55 East 52nd Street
New York City, NY 10055
United States

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