Real Risk, Inflation Risk, and the Term Structure

Abstract

I develop and estimate a general equilibrium model for the term structures of nominal and real interest rates in the UK that incorporates Markov-switching. The model allows for non-neutralities, nonlinear dynamics, and flexibility in the dynamics of the risk premia - features that are all present in the data. I use the model to assess how accurately the term structure reflects changing expectations of future yields and inflation. This analysis shows that the presence of time-varying risk premia make it very hard to accurately track changes in the expected path of real or nominal yields over horizons of less than five years. By contrast, variations in inflation expected over the next two to three years are very accurately reflected by changes in spread between real and nominal yields, or by changes in nominal yields alone. Over longer horizons, the term structures closely track changing expectations regarding future nominal and real yields but not future inflation.Term Structure, Risk Premia, Inflation Risk, Markov-Switching