After two types of inflation uncertainty are derived within a time-varying parameter model with GARCH specification, the relationship between inflation uncertainty and interest rates for safe assets is investigated. The results support the existence of a ‘‘flight to quality’’ effect.

Guler, Bulent

Ozlale, Umit

English

Research Papers in Economics

Physica A 345 (2005) 603–607
Is there a ﬂight to quality due to
inﬂation uncertainty?
Bulent Guler
a, Umit Ozlale
b,
aDepartment of Economics, Harkness Hall, University of Rochester, Rochester, NY 14627, USA
bDepartment of Economics, Bilkent University, Bilkent, Ankara 06800, Turkey
Received 8 March 2004
Available online 18 August 2004
Abstract
After two types of inﬂation uncertainty are derived within a time-varying parameter model
with GARCH speciﬁcation, the relationship between inﬂation uncertainty and interest rates
for safe assets is investigated. The results support the existence of a ‘‘ﬂight to quality’’ effect.
r 2004 Elsevier B.V. All rights reserved.
Keywords: Kalman ﬁlter; Generalized auto-regressive conditional heteroskedasticity; Flight to quality
effect
1. Introduction
Inﬂation uncertainty may affect interest rates for safer assets through two
distinct channels. First, an increase in uncertainty will raise the interest rates by an
increase in the inﬂation risk premium. Such a relationship is documented in several
studies like Refs. [1–4]. On the other hand, there is another channel,‘‘ﬂight to
quality’’, that has not been investigated previously in this context. According to
that view, an increase in inﬂation uncertainty might lead to a perceived increase in
economy-wide risk, prompting a ‘‘ﬂight to quality’’ by investors, in which their
ARTICLE IN PRESS
www.elsevier.com/locate/physa
0378-4371/$-see front matter r 2004 Elsevier B.V. All rights reserved.
doi:10.1016/j.physa.2004.07.038
Corresponding author. Tel.: +90-312-290-1584; fax: +90-312-266-5140.
E-mail address: ozlale@bilkent.edu.tr (U. Ozlale).demand for safe assets like treasury bills rises. This increase in demand for
these assets would tend to lower the associated interest rates. Therefore, a
negative relation between inﬂation uncertainty and interest rates for safe assets
may also exist.
This study takes the above discussion as its starting point and investigates the
validity of these two different channels for the United States economy. Apart from
the studies that have dominated the literature, inﬂation uncertainty is modelled in a
time-varying parameter framework with GARCH speciﬁcation. Such a methodology
is originally introduced by Evans (1991) [5] and can be used to identify several types
of inﬂation uncertainties: Uncertainty can either emerge from the randomness in the
structure of inﬂation process, that we name as ‘‘structural uncertainty’’, or it can be
generated by the shocks that hit the economy, which we name as ‘‘impulse
uncertainty’’. The effects of these two distinct types of uncertainties on safe assets
can vary signiﬁcantly.
We ﬁnd that while structural uncertainty effects treasury bills positively as
expected, impulse uncertainty generates a ‘‘ﬂight to quality’’ effect and it is
negatively associated with safe interest rates. The following section introduces the
methodology to model inﬂation uncertainty. Next, estimation results are presented.
The last section concludes.
2. Modelling inﬂation uncertainty
Consistent with Ref. [5], we employ a time-varying parameter model with
GARCH speciﬁcation. Formally,
ptþ1 ¼ Xtbtþ1 þ etþ1; where etþ1Nð0;htÞ ; (1)
btþ1 ¼ bt þ Vtþ1; where Vtþ1Nð0;QÞ ; (2)
ht ¼ h þ
X m
i¼0
fie2
t i þ
X n
i¼1
giht i ; (3)
where Xt is a vector of explanatory variables for inﬂation, known at time t: Lagged
values of inﬂation are used in the regressor matrix. btþ1 is a vector of parameters,
etþ1 is the shock to inﬂation that cannot be forecasted with information at time t: It is
normally distributed with a time-varying conditional variance of ht; which indicates
the changes in uncertainty of the future inﬂation at time t and it is speciﬁed as a
linear function of current and past squared forecast errors. Finally, fi and gi are the
time-varying parameters of ht . In this modelling, Eqs. (1) and (3) represent a generic
ARCH speciﬁcation of inﬂation, while Eq. (2) represents the change in the dynamics
of the inﬂation process over time.
ARTICLE IN PRESS
B. Guler, U. Ozlale / Physica A 345 (2005) 603–607 604Next, we should include the Kalman ﬁlter updating equations:
ptþ1 ¼ XtEtbtþ1 þ Ztþ1 ; (4)
Ht ¼ XtOtþ1jtXT
t þ ht ; (5)
Etþ1btþ2 ¼ Etbtþ1 þ½ Otþ1jtXT
t H 1
t  Ztþ1 ; (6)
Otþ2jtþ1 ¼½ I   Otþ1jtXT
t H 1
t Xt Otþ1jt þ Q ; (7)
where Otþ1jt stands for the conditional covariance matrix of btþ1 , which represents
uncertainty about the structure of the inﬂation process. The conditional variance of
inﬂation Ht depends upon both ht and the conditional variance of Xtbtþ1; which is
XtOtþ1jtXT
t ; formulated in Eq. (5). Therefore, two types of inﬂation uncertainties,
which govern the conditional variation in inﬂation, emerge: We can refer to inﬂation
uncertainty associated with randomness in b as ‘‘structural uncertainty’’, which is
denoted by XtOtþ1jtXT
t ; while uncertainty associated with the randomness in ‘‘e’’ is
called ‘‘impulse uncertainty’’ and it is represented by the conditional variance of etþ1;
which is ht: In other words, ‘‘e’’ can be viewed as describing the shocks that hit the
economy. Then, the time varying parameter b will show how these shocks are
propagated through the economy. Such a terminology leads us to Frisch and
Slutsky’s distinction between impulses and propagation.
The model is justiﬁed both in theoretical and empirical grounds in Ref. [5].
However, it may be useful to mention the theoretical justiﬁcation about assuming a
random walk about the evolution of parameters: Since changes in monetary policy,
which would be difﬁcult to predict, lead to structural variations in inﬂation, it is
convenient to assume that Etbtþ1 ¼ Etbt:
3. Results
We employ monthly US data from 1953:01 to 2002:11. Inﬂation series is obtained
by using consumer price index (CPI). Structural and impulse uncertainties are
derived using Eqs. (1) through (7). The optimal number of lags for the regressor
matrix in Eq. (1) is chosen according to Akaike and Schwarz information criteria.
Initially, three months effective treasury bill rate is regressed on structural and
impulse uncertainties. Since effective rates are used, expected inﬂation does not
appear on the right hand side. The results can be seen in the ﬁrst row of Table 1.
While structural uncertainty affects the interest rate positively, impulse uncertainty
moves the rates in the opposite direction. Moreover, when secondary market
treasury bill rates of same maturity is used, the results remained robust as it can be
seen in the second row of Table 1. Such a ﬁnding implies that structural uncertainty
increases interest rates, possibly through an increase in the inﬂation risk premium.
However, the negative impact of impulse uncertainty on the interest rates is an
evidence for ‘‘ﬂight to quality’’: an increase in impulse uncertainty occurs mostly
because the economy gets hit by a series of shocks, increasing the economy-wide risk
ARTICLE IN PRESS
B. Guler, U. Ozlale / Physica A 345 (2005) 603–607 605and prompting a ‘‘ﬂight to quality’’ by investors, in which their demand for safer
assets such as treasury bill rises, which, in turn, lowers their interest rates.
Finally, for robustness purposes, we regressed the spread between corporate bonds
(both AAA and BAA type of same maturity) and treasury bill rates on structural and
impulse uncertainties. Those types of bonds would presumably be viewed more risky,
so if the explanation works, their interest rates would rise with an increase in impulse
uncertainty, which would increase the spread between the two variables. The results
are displayed in the last four rows of Table 1. They imply that ‘‘ﬂight to quality’’
effect persists and increases the spread between riskier and safer assets. Another
interesting ﬁnding is that the impact of structural uncertainty on treasury bills is
larger than its impact on corporate bonds.
4. Conclusion
There are two distinct channels through which inﬂation uncertainty may affect
interest rates for safer assets like treasury bills. First, an increase in inﬂation risk
associated with higher uncertainty is expected to increase interest rates. Second, an
increase in uncertainty, which could also be viewed as a rise in economy-wide risk,
might generate a ‘‘ﬂight to quality’’ effect and increase the demand for safer assets,
which, in turn decreases their interest rates.
In this paper, we explored the validity of these two channels after decomposing
inﬂation uncertainty into two parts, namely structural and impulse uncertainty,
consistent with the methodology in Ref. [5]. We ﬁnd that while structural uncertainty
supports the ﬁrst channel and increases the interest rates for treasury bills, impulse
uncertainty generates a ‘‘ﬂight to quality effect’’ and decreases their interest rates.
ARTICLE IN PRESS
Table 1
Estimation results
Constant Structural Impulse
uncertainty uncertainty
Treasury bill 1.059212 (547.2715) 0.000510 ( 2.965591)  0.000674 ( 2.929100)
Secondary market 1.052955 0.000597  0.000779
Treasury Bill (578.0073) ( 3.685392) ( 3.595294)
AAA-treasury 0.016965 (20.98814)  0.000606 ( 8.436335) 0.000751 (7.812959)
BAA-treasurysec 0.031898 (32.31313)  0.000764 ( 8.699619) 0.000966 (8.222303)
BAA-treasury 0.025642 (28.51066)  0.000677 ( 8.465972) 0.000861 (8.046029)
AAA-treasurysec 0.023222 (26.81198)  0.000693 ( 8.997980) 0.000856 (8.308233)
Note: t-statistics are reported in the parentheses.
B. Guler, U. Ozlale / Physica A 345 (2005) 603–607 606Moreover, the implications remained robust when spreads between riskier corporate
bonds and treasury bills are used.
Acknowledgements
We are grateful to M. Evans and Peter N. Ireland for their kind help and
suggestions. The usual disclaimer applies.
References
[1] F.S. Mishkin, The real interest rate: an empirical investigation, Carnegie–Rochester Conf. Ser. Public
Policy 15 (1981) 151–200.
[2] E. Fama, M. Gibbons, Inﬂation, real returns and capital investment, J. Monetary Econ. 9 (1982)
297–323.
[3] L.K.C. Chan, Consumption, inﬂation risk, and interest rates: an empirical analysis, J. Bus. 67 (1994)
69–96.
[4] H. Berument, The impact of inﬂation uncertainty of interest rates in the UK, Scottish J. Polit. Econ. 46
(1999) 207–218.
[5] M. Evans, Discovering the links between inﬂation rates and inﬂation uncertainty, J. Money Credit
Banking 23 (1991) 169–184.
ARTICLE IN PRESS
B. Guler, U. Ozlale / Physica A 345 (2005) 603–607 607

Is there a flight to quality due to inflation uncertainty?

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics