Information Content of the Term Structure of Interest Rates

Information Content of the Term Structure of Interest Rates

Abstract

I investigate the information content of the nominal and real term structure of interest rates for the United Kingdom for the period 1985-2004. The United Kingdom has the longest experience among developed countries with issuing inflation-indexed securities, and it is the only country with a sufficient number of outstanding index-linked bonds to permit the estimation of a well specified real yield curve. My first essay uses inflation expectation proxies derived from the term structure for the estimation of a forward-looking Phillips curve. My second paper deals with the predictive power of the term structure regarding future changes in monetary policy. My third essay considers a simultaneous New Keynesian model of inflation, output and monetary policy. The Tradeoff between Inflation and the Real Economy, Forward-Looking Behavior and the Inflation Premium (with Richard Startz)In this paper we use the inflation premium as an alternative proxy for expected inflation in the context of the New Keynesian Phillips Curve. The inflation premium, thedifference between the nominal and the real interest rate derived from inflation-linked securities, as a measure of expected inflation has the advantage that it is by construction forward looking and frequently updated. Using this alternative proxy for inflationexpectations we estimate a forward-looking Phillips curve for the United Kingdom over the period 1985-2004. The proposed model describes UK inflation dynamicsconsiderably better than the standard hybrid New Keynesian Phillips Curve under the assumption of rational expectations. In contrast with the findings in the rest of the literature we find that there still exists a tradeoff between inflation and the stance of the real economy regardless of the empirical measure used. This relationship also persists in the period since the UK adopted inflation targeting as a framework for monetary policy.

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2The Term Structure of Interest Rates and Monetary Policy PredictabilityThe second chapter looks at the information content of the yield curve about future monetary policy changes and the credibility of the bank's commitment to keeping inflation low. Augmenting the standard Expectations Hypothesis based estimationequation with real yield curve variables I focus on the predictability