Nominal Interest Rates as Indicators of Inflation Expectations

Forward interest rates have become popular indicators of inflation expectations. The usefulness of this indicator depends on the relative volatility and the correlation of inflation expectations and expected real interest rates. This paper studies US and UK data, using a range of different tools and data sets. The forward rate rule performs reasonably well, in spite of significant movements in the expected real interest rate. The reason is that the 'noise' that movements in the expected real interest rate add to the inflation expectations is balanced by a tendency for expected real interest rates and inflation expectations to move in opposite directions.

[1]  Walter L. Smith.  Probability and Statistics , 1959, Nature.

[2]  J. Huston McCulloch,et al.  U.S. term structure data, 1947-1991 , 1993 .

[3]  C. Nelson,et al.  On testing the hypothesis that the real rate of interest is constant , 1977 .

[4]  Lars E. O. Svensson.  Monetary Policy with Flexible Exchange Rates and Forward Interest Rates as Indicators , 1994 .

[5]  R. Bliss.  Testing Term Structure Estimation Methods , 1996 .

[6]  An Empirical Measure of the Real Rate of Interest , 1995 .

[7]  A. Irturk,et al.  Term Structure of Interest Rates , 2006 .

[8]  Kenneth A. Froot.  New Hope for the Expectations Hypothesis of the Term Structure of Interest Rates , 1987 .

[9]  Martin D. D. Evans.  Index-Linked Debt and the Real Term Structure: New Estimates and Implications from the U.K. , 1996 .

[10]  Martin D. D. Evans,et al.  Do expected shifts in inflation affect estimates of the long-run Fisher relation? , 1995 .

[11]  Andrew Harvey,et al.  Forecasting, Structural Time Series Models and the Kalman Filter , 1990 .

[12]  Clive W. J. Granger,et al.  Prediction with a generalized cost of error function , 1969 .

[13]  Lars E. O. Svensson,et al.  New Techniques to Extract Market Expectations from Financial Instruments , 1997 .

[14]  Douglas H. Joines.  Short-Term Interest Rates as Predictors of Inflation: Comment , 1977 .

[15]  E. Fama,et al.  Short-Term Interest Rates as Predictors of Inflation , 1975 .

[16]  Frederic S. Mishkin.  Is the Fisher Effect for Real? A Reexamination of the Relationship between Inflation and Interest Rates , 1991 .