The Term Structure of Interest Rates and Inflation Forecast Targeting

S.C.W. Eijffinger, E. Schaling, W.H. Verhagen

Research output: Working paperDiscussion paperOther research output

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Abstract

This paper examines the implications of the expectations theory of the term structure for the implementation of inflation targeting. We show that the term structure weakens the transmission of short term interest rates to ultimate policy objectives. Therefore, short term interest rates in the central bank's forward looking monetary policy rule need to respond more strongly to the output gap and deviations of inflation from its target. Thus, in general the term structure implies a higher degree of policy activism. Next, we show that both the sensitivity of the term spread to economic fundamentals, and the extent to which the spread predicts future output, are increasing in the duration of the long bond and the degree of structural output persistence. If the central bank becomes relatively less concerned about inflation stabilisation the term spread becomes less sensitive to fundamentals, and the spread will be less successful in predicting real economic activity.
Original languageEnglish
Place of PublicationTilburg
PublisherMacroeconomics
Number of pages23
Volume1998-85
Publication statusPublished - 1998

Publication series

NameCentER Discussion Paper
Volume1998-85

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Term structure of interest rates
Inflation forecasts
Targeting
Term structure
Short-term interest rates
Central bank
Term spread
Economic fundamentals
Inflation stabilization
Deviation
Activism
Output persistence
Inflation
Inflation targeting
Output gap
Monetary policy rules
Economic activity
Expectations theory

Keywords

  • term structure of interest rates
  • inflation targets

Cite this

Eijffinger, S. C. W., Schaling, E., & Verhagen, W. H. (1998). The Term Structure of Interest Rates and Inflation Forecast Targeting. (CentER Discussion Paper; Vol. 1998-85). Tilburg: Macroeconomics.
Eijffinger, S.C.W. ; Schaling, E. ; Verhagen, W.H. / The Term Structure of Interest Rates and Inflation Forecast Targeting. Tilburg : Macroeconomics, 1998. (CentER Discussion Paper).
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Eijffinger, SCW, Schaling, E & Verhagen, WH 1998 'The Term Structure of Interest Rates and Inflation Forecast Targeting' CentER Discussion Paper, vol. 1998-85, Macroeconomics, Tilburg.

The Term Structure of Interest Rates and Inflation Forecast Targeting. / Eijffinger, S.C.W.; Schaling, E.; Verhagen, W.H.

Tilburg : Macroeconomics, 1998. (CentER Discussion Paper; Vol. 1998-85).

Research output: Working paperDiscussion paperOther research output

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AU - Verhagen, W.H.

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PY - 1998

Y1 - 1998

N2 - This paper examines the implications of the expectations theory of the term structure for the implementation of inflation targeting. We show that the term structure weakens the transmission of short term interest rates to ultimate policy objectives. Therefore, short term interest rates in the central bank's forward looking monetary policy rule need to respond more strongly to the output gap and deviations of inflation from its target. Thus, in general the term structure implies a higher degree of policy activism. Next, we show that both the sensitivity of the term spread to economic fundamentals, and the extent to which the spread predicts future output, are increasing in the duration of the long bond and the degree of structural output persistence. If the central bank becomes relatively less concerned about inflation stabilisation the term spread becomes less sensitive to fundamentals, and the spread will be less successful in predicting real economic activity.

AB - This paper examines the implications of the expectations theory of the term structure for the implementation of inflation targeting. We show that the term structure weakens the transmission of short term interest rates to ultimate policy objectives. Therefore, short term interest rates in the central bank's forward looking monetary policy rule need to respond more strongly to the output gap and deviations of inflation from its target. Thus, in general the term structure implies a higher degree of policy activism. Next, we show that both the sensitivity of the term spread to economic fundamentals, and the extent to which the spread predicts future output, are increasing in the duration of the long bond and the degree of structural output persistence. If the central bank becomes relatively less concerned about inflation stabilisation the term spread becomes less sensitive to fundamentals, and the spread will be less successful in predicting real economic activity.

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Eijffinger SCW, Schaling E, Verhagen WH. The Term Structure of Interest Rates and Inflation Forecast Targeting. Tilburg: Macroeconomics. 1998. (CentER Discussion Paper).