Real rates, expected inflation and

inflation risk premia implicit

in nominal bond yields

Andrea Berardi 1
Università di Verona

October 21, 2005

1 SAFE Center, Department of Economics, Università di Verona, via Giardino

Giusti 2, 37129 Verona, Italy. E-mail: andrea.berardi@univr.it.
 Abstract

In this paper we propose a structural term structure model which provides

endogenous estimates of the term structures of real interest rates, inflation
expectations and inflation risk premia by relying exclusively on observations
on nominal bond yields and macro variables. The model also allows us to
shed some light on the implicit monetary policy reaction function of the cen-
tral bank in response to a change in the market expectations about future
inflation and output growth. Estimation uses monthly data over the 1991
to 2004 sample period for a set of countries including the U.S., the U.K.,
Japan, Germany, France and Italy. The empirical analysis produces reliable
estimates of the implicit term structures of real interest rates, inflation ex-
pectations and inflation risk premia and indicates that there are significant
interrelations across countries. We find that real rates and inflation expecta-
tions exhibit a positive correlation, which contradicts both the Fisher relation
and the Mundell-Tobin effect, and that inflation risk premia vary significantly
over time and across maturities. The evidence shows that there is a strict
link between the estimated output growth and inflation expectations and the
interest rate policy implemented by the central banks.

JEL Classification: E43, E44, E58, G10

Keywords: term structure and macroeconomy, real interest rates, infla-
tion expectations, inflation risk premium, monetary policy
1 Introduction
The study of the relationship between nominal and real interest rates and
inflation expectations dates back to the seminal work of Fisher (1930) and
the fundamental contributions of Mundell (1963), Tobin (1965), Fama (1975),
Fischer (1975), Mishkin (1981) and Benninga and Protopapadakis (1983).
In recent years, this area of research has received new impulse by the
empirical evidence provided, among the others, by Pennacchi (1991), Sun
(1992), Boudoukh (1993), Pearson and Sun (1994), Gong and Remolona
(1996), Ang and Bekaert (2003), Goto and Torous (2003) and Buraschi and
Jiltsov (2005) for the U.S., Deacon and Derry (1994), Brown and Schaefer
(1994 and 1996), Barr and Campbell (1997), Remolona, Wickens and Gong
(1997), Evans (1998 and 2003) and Seppala (2004) for the U.K., Kandel, Ofer
and Sarig (1996) for Israel.
Analyzing the link between real interest rates, inflation expectations and
inflation risk premia is relevant both for investment and monetary policy
decisions. In the U.K., for example, inflation-indexed bond prices are used
by the Bank of England to infer inflation expectations and hence to determine
the conduct of the monetary policy. At the same time, index-linked bonds
are particularly suitable financial instruments for the investment strategies
of institutional investors, such as, for example, pension funds and insurance
companies.
At present, the U.K. index-linked gilts market is the only large and liquid
market of inflation-indexed bonds with a relatively long history of data. In
fact, index-linked gilts were first issued in 1981 and currently account for
a relevant portion of the U.K. Government securities market (about 25%
of outstanding issues by market value). The U.S. have initiated the issue
of inflation-linked bonds (denominated TIPS) only in 1997, although this
market has rapidly grown and currently represents almost 10% of the out-
standing amount of Treasury securities. More recently, EU countries, such
as Germany, France and Italy, have also started issuing this type of bonds.
Observing the dynamics of both bond prices denominated in nominal
terms and bond prices denominated in real terms would allow one to separate
the nominal yield of any maturity into its components, i.e., the real interest
rate, the expected inflation rate and the inflation risk premium. However, in
most countries, only bond prices expressed in nominal terms are available.
The main contribution of this paper consists in providing a model for the
estimation of the term structures of real interest rates, inflation expectations
and inflation risk premia which relies exclusively on observations on nominal
bond yields and macro variables.
By exploiting the cross-sectional restrictions which link the dynamics of

1
bond yields, output growth and inflation in the context of a no-arbitrage
term structure setting1 , we derive a structural model providing endogenous
closed form solutions for the equilibrium value of nominal and real bonds
and for inflation expectations and inflation risk premia over any future time
interval. Moreover, the model allows us to get an estimate of output growth
expectations and use these forecasts, along with inflation expectations, to
make some inference on the implicit monetary policy reaction function of the
central bank.
Estimation uses monthly data over the 1991 to 2004 sample period for a
set of countries including the U.S., the U.K., Japan, Germany, France and
Italy. A maximum likelihood - Kalman filter technique is applied to estimate
the parameters and the unobserved state variables.
The empirical analysis produces reliable estimates of the implicit term
structures of real interest rates, inflation expectations and inflation risk pre-
mia and indicates that there are significant interrelations across countries.
Real rates and inflation expectations exhibit a positive correlation, which
contradicts both the Fisher relation and the Mundell-Tobin effect, whereas
inflation risk premia vary significantly over time and across maturities. More-
over, the evidence shows that there is a significant link between the estimated
output growth and inflation expectations and the interest rate policy imple-
mented by the central banks.
The plan of the paper is the following. Section 2 illustrates the structural
term structure model. Section 3 describes the data, the estimation method
and the empirical results. Section 4 shows the properties of the estimated
term structures of real interest rates, inflation expectations and inflation risk
premia and provides some evidence on the interest rate policy of the central
banks. Section 5 concludes.

2 The model
The theoretical model is consistent with the assumptions underlying the
Cox, Ingersoll and Ross (CIR, 1985a and 1985b) general equilibrium frame-
work. We assume that there is a single technology producing a single physi-
cal good and that the price level is exogenously determined by the monetary
policy. The dynamics of the economy is assumed to be driven by the instan-
taneous real interest rate r, the instantaneous expected inflation rate π and
1
Recent examples of no-arbitrage term structure models relating interest rates to macro
variables include, among the others, den Haan (1995), Bakshi and Chen (1996), Wu (2001),
Ang and Piazzesi (2003), Ang, Piazzesi and Wei (2004), Berardi and Torous (2005) and
Dewachter and Lyrio (2005).

2
their time-varying central tendencies, r and π, respectively. Moreover, we
include as a factor a zero-mean variable x, which represents a shock to the
conditional mean of output growth. This allows the expected rate of growth
of the production process to differ in some periods from the sum of the real
interest rate and the variance of the production process, as would predict,
instead, the CIR (1985a) general equilibrium model2 .
Under the physical probability measure, the state variables are assumed
to follow a multivariate gaussian process of the form:

dS = (ΦS + ΓS · S) dt + ΣS · dZS (1)

where:
     
r 0 γ rr 0 −γ rr 0 0
     


π 



0 



γ πr γ ππ −γ πr −γ ππ 0 

S≡
 r ,
 ΦS ≡ 
 φr ,
 ΓS ≡ 
 0 0 γ rr 0 0 

     
 π   φπ   0 0 γ πr γ ππ 0 
x 0 0 0 0 0 γ xx

ΣS is a diagonal matrix and ZS a vector of standard Brownian motions.

We assume that production output, q, and the price level, p, also evolve
according to gaussian-type processes:
dM
= (ΦM + ΓM · S) dt + ΣM · dZM (2)
M
where:
à ! à ! à !
dM dq/q σ 2q 1 0 0 0 1
≡ , ΦM ≡ , ΓM ≡
M dp/p 0 0 1 0 0 0

ΣM is a diagonal matrix, with elements σ q and σ p , and ZM is a vector of

standard Brownian motions. These are correlated with correlation coefficient
ρ.
Applying Ito’s Lemma to equation (2), we can derive a process for the
rate of growth of production and the price level over a time interval [t, t + ω].
Both these expressions and the stochastic differential equations in (1) have
a closed form solution3 :

Et {S(t + ω)} = AS (ω) + BS (ω) · S(t) (3)

2
On this point, see also Breeden (1986).
3
The functional form of the coefficients in the closed form solution of the model (equa-
tions (3-7) and (9-10) below) is illustrated in the Appendix.

3
 Covt {S(t + ω), S(t + ω)0 } = CS (ω) (4)
(Ã !)
(1/ω) ln (q(t + ω)/q(t))
Et = AM (ω) + BM (ω) · S(t) (5)
(1/ω) ln (p(t + ω)/p(t))
(Ã ! Ã !0 )
(1/ω) ln (q(t + ω)/q(t)) (1/ω) ln (q(t + ω)/q(t))
Covt , = CM (ω)
(1/ω) ln (p(t + ω)/p(t)) (1/ω) ln (p(t + ω)/p(t))
( Ã !0 )
(6)
(1/ω) ln (q(t + ω)/q(t))
Covt S(t + ω), = CSM (ω) (7)
(1/ω) ln (p(t + ω)/p(t))
Equation (5) provides endogenous expectations for economic growth and
inflation over any future time horizon.
In modelling factor risk premia, we use the Duffee (2002) “essentially
affine” specification, which implies that the market price of risk can vary
independently of interest rate volatility. This hypothesis consists in assuming
that the market price of risk is affine in the state variables:

Λ(t) ≡ Λ0 + Λ1 · S(t) (8)

where Λ0 and Λ1 are defined as follows:
   
λ0r λrr 0 −λrr 0 0
   


λ0π 



λπr λππ −λπr −λππ 0 

Λ0 ≡ 
 λ0r ,
 Λ1 ≡ 
 0 0 λrr 0 0 

   
 λ0π   0 0 λπr λππ 0 
0 0 0 0 0 0

The closed form solution of the model allows us to express the yield at
current time t of a nominal unit discount bond with maturity date t + τ as
an affine function of the state variables:

Y (t; t + τ ) = κ0 (τ ) + κ(τ ) · S(t) (9)

Similarly, the expression for the yield at current time t of a real unit
discount bond with maturity date t + τ is given by:

y(t; t + τ ) = µ0 (τ ) + µ(τ ) · S(t) (10)

The size of the inflation risk premium in the nominal term structure
depends on the ability of the bonds in providing a hedge against a decrease
in consumption4 and is a function of the covariance between inflation and
4
See, among the others, Benninga and Protopapadakis (1983) and Breeden (1986).

4
output growth. The inflation risk premium at time t on a bond with maturity
τ can be expressed as:

( ) ( )
1 p(t + τ ) 1 p(t + τ )
IRP (t; t+τ ) = Y (t; t+τ )−y(t; t+τ )− Et ln + V art ln
τ p(t) 2τ p(t)
(11)
By construction, instantaneous expected excess returns on nominal bonds
are also time-varying:

EER(t; t + τ ) = −τ · κ(τ ) · ΣS (Λ0 + Λ1 · S(t)) (12)

We notice that expected excess returns are affine in the state variables,
which implies that we can measure the contribution of each factor to the
total expected risk premium.

3 Model estimation
In this section, we first illustrate the data and the econometric technique
used in estimating the model. Then, we show the estimated parameters and
state variables and evaluate the goodness of fit of the model with respect to
bond yields and macro variables.

3.1 Data
The model is estimated for six countries, i.e., the U.S., the U.K., Japan,
Germany, France and Italy. We use monthly data over the sample period
June 1991 to March 2004 (154 observations). The nominal yields considered
for estimation are end-of-month euro and swap rates with maturities six
months, two, five and ten years. As pointed out by Dai and Singleton (2000),
the use of swap rates rather than Treasury yields can be motivated by the
fact that swap rates are true market constant maturity yields and are not
approximated by interpolation, as in the case of Treasury yields. Moreover,
they are not affected by repo market effects, such as “specialness”.
As a measure of economic activity we use seasonally adjusted data on
the industrial production index, whereas seasonally adjusted data on the
consumer price index are used as a proxy for the price level. The rates of
growth calculated over the three and six months time horizons are included
in the estimation sample.

5
3.2 Estimation method
The discrete time state space specification corresponding to the continuous
time theoretical model developed above takes the following form:

Xt = J + H · St + et (13)
St = AS + BS · St−1 + η t (14)
where the time interval is one month, Xt is the vector which includes the
observed nominal yields and rates of growth of the macro variables, i.e.,
production output and price level, and St is the vector of unobservable state
variables.
The structure of the coefficients implies that cross-equation restrictions
must be imposed on the model, as the vectors J and AS and the matrices H
and BS in the state space form are nonlinear functions of the original model
parameters in equations (1-2) and (8). In particular, the vector J includes
the coefficients κ0 (τ ) of equation (9), with τ = six months, two, five and ten
years, and the coefficients AM (ω) of equation (5), with ω = three and six
months, whereas the matrix H includes the coefficients κ(τ ) of equation (9),
with τ = six months, two, five and ten years, and the coefficients BM (ω) of
equation (5), with ω = three and six months. The vector AS and the matrix
BS correspond, respectively, to AS (ω) and BS (ω) of equation (3), with ω =
one month.
The error terms et and η t are assumed to be normally and independently
distributed. For the covariance matrices relating error terms in the state
variables, output growth and inflation we impose all the cross-equation re-
strictions implied by the equations (4) and (6).
The deviation of actual yields from their theoretical values is assumed to
be due to “observation error”. In order to limit the number of parameters
which must be estimated, we assume that these errors are mutually uncor-
related and cross-sectionally homoskedastic. The errors in the equations for
output growth and inflation measured over a time interval [t, t + ω] are “fore-
casting errors”, which arise from the difference between actual and expected
values for output growth and inflation. We assume that observation errors
in bond yields and forecasting errors in ω-period output growth and inflation
are uncorrelated.
The parameters of the state space model are estimated by the maximum
likelihood method with the Kalman filter algorithm used to calculate the
values of the unobserved state variables5 .
5
See, for example, Anderson and Moore (1979).

6
3.3 Parameters and state variables
Table 1 reports the estimated parameter values under the physical prob-
ability measure.
We notice that, in all the countries considered, the real interest rate
exhibits a relatively strong mean reversion towards its time-varying central
tendency. We calculate that the half-life, i.e., the time it takes for the variable
to return half way towards its initial value in response to a shock equal to one
standard deviation, is about one year, on average. The expected inflation rate
also has significant mean reversion. This result is consistent with Jegadeesh
and Pennacchi (1996) claiming that the expected inflation rate shows a mean
reverting behavior once we allow its central tendency to be stochastic.
The central tendency of the real rate reverts quickly towards its long-term
mean, with an average half-life around 1.5 years, whereas the central tendency
of the expected inflation rate seems to behave almost like a random walk. As
expected, the unobservable shock variable x affecting the conditional mean of
output growth is significantly mean reverting towards zero, with coefficients
which are very similar across countries.
We observe that the risk premia coefficients in Λ0 and Λ1 are generally
statistically significant and seem to support the essentially affine specification
adopted in the theoretical framework.
By measuring the sensitivity of nominal yield changes to innovations in
the state variables, i.e, the effect on nominal yields of a one standard devia-
tion innovation in the variables, we observe very similar patterns in the six
countries6 . In particular, the impact of shocks in the central tendency of the
expected inflation rate is almost constant across maturity, which means that
this factor mainly accounts for parallel shifts in the yield curve. Innovations
in the real interest rate and the expected inflation rate, instead, have a sig-
nificant impact on the short end of the nominal yield curve and almost no
effect on the long end. This implies that these factors can explain changes
in the slope of the term structure. The central tendency of the real interest
rate seems to affect the curvature of the yield curve, as its innovations have a
hump-shaped impact on yields, with a peak around the three-year maturity.
Figure 1 shows the Kalman filter estimates of the unobservable state
variables, that is, the instantaneous real interest rate and expected inflation
rate and their time-varying central tendencies.
We notice that the real interest rate in the U.S. sharply decreases during
both the 1991-92 and the 2001-02 recessions, whereas the expected inflation
rate remains relatively stable over the sample period at around 2.5%. Instead,
in the case of Japan, which has experienced a prolonged period of recession
6
For brevity, these figures are not reported in the paper.

7
during the Nineties, we observe even negative values for the expected inflation
rate and its central tendency. Only in the first part of the sample, with actual
long-term interest rates around 8%, is the central tendency of the expected
inflation rate relatively high.
The real interest rate in the European countries shows a declining trend
starting in October 1992, that is after the ERM monetary crises, which
mainly affected the British pound and the Italian lira. In the case of Ger-
many, France and Italy, we also observe a sharp decline in expected inflation
and its central tendency in the years preceding the start of the EMU in 1999.
In the recent years following the Internet bubble (2001-2004), the real in-
terest rate and its central tendency tend to become extremely low, or even
negative.

3.4 Goodness of fit

In table 2 we analyze the in-sample adequacy of the model in fitting bond
yields, inflation and output growth.
Panel A of the table reports summary statistics on bond yields estimation
errors. In general, the yield errors generated by the model are relatively low,
with no evidence of systematic under/over pricing. The mean of the errors
is very close to zero and root mean squared errors are below 5 basis points.
It is worth noting that the model fits well also the off-the-run yields, i.e., the
yields not included in the estimation sample (three-, four- and seven-year
maturity yields).
Panel B of the table shows the results of the regression of realized IPI and
CPI growth rates against their corresponding expectations generated by the
model estimates. We observe that at the six-month horizon both the output
growth and inflation expectations produced by the model are unbiased esti-
mators of future output growth and inflation rates, as we cannot reject the
null hypothesis that the slope coefficient of the regression is not statistically
different from one. Instead, the shorter (three months) and the longer (one
year) horizon predictions tend to underestimate and overestimate, respec-
tively, actual values. As a benchmark for the predictive power of the model
estimates, we use two well known alternative approaches, i.e., the Harvey
(1988 and 1989) regression for output growth and the Fama (1990) - Mishkin
(1990) regression for inflation. The Harvey model consists in regressing the
output growth rate realized between time t and t + τ against the spread
between the long and the short interest rate observed at time t. Similarly,
the Fama-Mishkin model is based on the regression of inflation rates realized

8
between time t and t + τ against the interest rate spread observed at time t7 .
The model predictions look considerably more precise than those provided
by the alternative models, both in the case of output growth and in the case
of inflation. In particular, we observe that the Harvey and the Fama-Mishkin
models seem to contain some explanatory power only for the EU countries.

4 Real rates, expected inflation and inflation

risk premia
The model allows us to extrapolate the unobservable term structures of
real interest rates, expected inflation rates and inflation risk premia. In this
section, we analyze the dynamics of these variables. Moreover, we provide
some evidence on the implicit monetary policy response functions of the
central banks of the countries considered.

4.1 Term structures of real interest rates and inflation

expectations
Table 3 contains summary statistics on the estimated term structures of
real interest rates and expected inflation rates, whereas figure 2 shows the
time series behaviour of the level, slope and curvature of those term struc-
tures. The “level” is calculated as the average of the one-, five- and ten-year
maturity rates, the “slope” as the difference between the ten-year and the
one-year rates and the “curvature” as the sum of the one-year and the ten-
year rates minus twice the five-year rate.
We observe that, on average, real yield curves are upward sloping, with
a spread between long and short term maturities which varies significantly
across countries. The term structure of actual expected inflation rates is,
on average, almost flat for Germany and Italy and positively sloped for the
U.S., the U.K. and France. In the case of Japan, instead, the term structure
of inflation expectations is very steep, with short-term rates which are very
low in comparison with the other countries.
The volatility of real interest rates decreases with maturity in all coun-
tries, whereas the shape of the term structure of the volatility of expected
inflation rates differs across countries.
7
We estimate the two models using as a spread the difference between the ten-year and
the two-year maturity nominal yields. However, using yields with different maturities (five
years for the long-term yield and six months for the short-term yield, for example) does
not change significantly the results.

9
 We notice that in Germany, France and Italy real rates are considerably
higher than actual expected inflation rates both at short term and long term
maturities. This might be the effect of the anti-inflationary monetary policy
carried out in these countries during the Nineties in order to accelerate the
process of convergence towards the Maastricht criteria. Indeed, we observe
that inflation expectations reach their minimum around the end of 1998, i.e.,
right before the starting of the EMU. It is interesting to note that a similar
pattern is observed in the U.K., a fact which might be interpreted as an
implicit link between the monetary policy of the Bank of England and that
of the European Central Bank.
We notice that in the U.S. the level of real interest rates tends to decrease
well below the level of expected inflation rates during the periods of recession
experienced at the beginning and the end of the sample period, i.e., during
the easing of the Federal Reserve monetary policy.
In Japan, real rates are generally very low and the level of expected
inflation rates is observed to fall below zero in the second part of the sample
as a consequence of the prolonged period of stagnation.
Apparently, the monetary authorities of the six countries control inflation
by piloting real interest rates, as the observed correlation between the level
of real interest rates and official discount rates is very high (about 0.9, on
average) in each country. We notice that, starting in 1998, when inflation has
become relatively stable in all countries, both the slope and the curvature
of the nominal term structures seem to be almost exclusively determined by
movements in real interest rates. A significant exception is represented by
Japan, where the features of the nominal yield curve appear to be mainly
affected by inflation expectations.
The correlation between the level (and the monthly changes) of real inter-
est rates and expected inflation rates is positive in all countries and relatively
high in the case of the EU countries. According to Goto and Torous (2003),
this might be due to the fact that the central bank strictly controls inflation,
as nominal interest rates move more than one-for-one with inflation expec-
tations inducing a positive relation between real interest rates and expected
inflation. In fact, the slope coefficients of the regression of τ -maturity nomi-
nal yields against τ -maturity real interest rates and expected inflation rates
are significantly higher than one8 .
The first implication of this evidence is that the “Fisher relation” is not
satisfied. In fact, the standard view commonly referred to as “Fisher rela-
tion” implies, in its strictest form, that changes in nominal interest rates are
exclusively determined by expected inflation and therefore that no role is
8
For brevity, the results of these regressions are not included in the paper.

10
played by the real interest rate, which is assumed to be almost constant. A
corollary of this theory is that real interest rates are not affected by inflation
and, therefore, inflation plays a very limited role in influencing the real side
of the economy. This view, initially advanced by Fama (1975), has little
to do with the original work of Fisher (1930)9 , and has been the subject of
intensive research over a long period. Mishkin (1992) and Evans and Lewis
(1995), for example, show that the Fisher effect holds only in the long run.
A second relevant implication is that the so-called “Mundell (1963) -
Tobin (1965) effect” is also violated.
The Mundell-Tobin framework would predict that higher inflation expec-
tations involve higher nominal interest rates and, consequently, a shift in
the holdings from money to bonds, which are interest-earning assets. The
increase in the demand for bonds reduces their expected real return and
results in a negative correlation between the real interest rate and expected
inflation. A different explanation for the negative correlation between real in-
terest rates and expected inflation has been advanced by Fama and Gibbons
(1982). They suggest that in equilibrium real interest rates must increase
with increasing capital expenditures in order to induce shifts of resources
from consumption to investment. A negative relation between inflation and
real activity is justified in terms of a simple monetary model combining the
money demand theory with the Fisher quantity theory of money. This im-
plies that if the expansionary process generated by the increased capital ex-
penditure is not accommodated by an adequate variation in nominal money
growth, then the equilibrium in the money market can be obtained only if
inflation falls. Therefore, to the positive change in the real interest rate
associated to the increase in capital expenditure corresponds an expected
decrease in inflation.
Apparently, the restrictive interest rate policies adopted by the central
banks during the Nineties have more than compensated the effects predicted
either by the Mundell-Tobin or the Fama-Gibbons models. This result is
consistent with the evidence for the U.S. presented by Goto and Torous
(2003), claiming that a change in regime has taken place in the relation
between real interest rates and expected inflation since the 1979-82 “Volcker
experiment”.
The correlation between the slope of the term structure of real rates and
9
In contrast with the implications of the commonly denominated “Fisher effect”, Fisher
(1930, p.43) writes: “When the cost of living is not stable, the rate of interest takes
the appreciation and depreciation into account to some extent, but only slightly and, in
general, indirectly. That is, when prices are rising, the rate of interest tends to be high
but not so high as it should be to compensate for the rise; and when prices are falling, the
rate of interest tends to be low, but not so low as it should be to compensate for the fall.”

11
the slope of the term structure of expected inflation rates is significantly
negative. This means that when real rates increase at all maturities with a
simultaneous steepening of the real curve, expected inflation rates tend to
increase in level, but with a flattening of the expected inflation curve. This
effect might indicate that market expectations are formed on the basis of a
credible anti-inflationary interest rate policy by the central banks.

4.2 Cross-country analysis

Looking at the estimated term structures of real interest rates and infla-
tion expectations on a cross-country perspective, we observe that real rates
appear to be highly correlated across the European area. In particular, the
correlation between monthly changes in real interest rates in the U.K., Ger-
many, France and Italy at the various maturities is around 60%, on average.
Medium and long term real rates in the U.S. are only mildly positively cor-
related with the corresponding real rates in Europe, whereas Japanese real
interest rates do not appear to be correlated with those of the other countries.
Similarly, we observe that inflation expectations at the different time
horizons are significantly positively correlated among the European countries,
especially between Germany and France. Positive is also the correlation
between expected inflation rates in Europe and the U.S., whereas, again,
expectations in Japan seem to be behave independently of the other countries.
This evidence is reinforced by a principal components analysis applied to
monthly changes in the estimated real interest rates and expected inflation
rates. For simplicity, we consider only one short (one-year), one medium
(five-year) and one long (ten-year) maturity rate for each country.
Table 4 summarizes the results of the principal components analysis. In
the case of real interest rates, we observe that the first principal component
explains about 45% of the total variability and is highly correlated with
real rates in the European countries. The second and the third principal
components, accounting for 18% and 12%, respectively, of the total variability
of real yields, are mainly related to the real term structure rates in the U.S.
and Japan.
As regards expected inflation rates, the first principal component ex-
plains 46% of the variability and is correlated with inflation expectations in
the U.S. and the European area. The second principal component (15% of
total variance), instead, explains movements in the Japanese term structure
of inflation expectations. Interestingly, the third and the fourth principal
components (10% and 9% of total variability) are only related to Italy and
the U.K., respectively, denoting some specific elements in the dynamics of
inflation expectations in these two countries.

12
 Similarly, by applying the principal components analysis to monthly changes
in the estimated nominal yields, we observe that the first principal compo-
nent is common to the U.S. and the European countries and the second one
is related only to Japan.

4.3 Inflation risk premia

Table 5 contains summary statistics on the estimated inflation risk premia
and instantaneous expected excess returns on nominal bonds. Figure 3 shows
the time series dynamics of these variables.
Inflation risk premia vary significantly over time and across maturities.
We notice a clear declining trend in inflation risk premia for all the countries
considered. In the U.S., the U.K. and Japan, inflation risk premia become
even negative in the second part of the sample, whereas in the EU countries
inflation risk premia decrease almost constantly since the starting of the
convergence process towards the Maastricht criteria.
The dynamics of inflation risk premia seems to denote the fact that,
since the mid-Nineties, when actual and expected inflation rates stabilize
around a value which is well below their long-term means in all the countries
considered, the covariance between inflation and investors’ marginal utility
diminishes and, consequently, the inflation risk premium required on nominal
bonds decreases towards zero.
The slope of the term structure of inflation risk premia is generally posi-
tive, with average short term maturities close to zero and average long term
maturities around 30-40 basis points. The average term structure of the
volatility of inflation risk premia also increases with maturity.
Estimated instantaneous expected excess returns on nominal bonds also
decline over time. In the case of the U.S., the U.K. and Japan expected
excess returns are mainly determined by the inflation components, i.e., the
instantaneous expected inflation rate and its time-varying central tendency.
As an effect, we observe that they are highly correlated with inflation risk
premia both at short term and long term maturities. Instead, in the case of
the EU countries, instantaneous excess bond returns are almost exclusively
determined by the long-term means of the real interest rate and the expected
inflation rate. The correlation with inflation risk premia is very low, if not
negative, at short term maturities and relatively high at long term maturities.
In panel A of table 6, we investigate the correlation between movements
in the inflation risk premia and the spread between nominal and real inter-
est rates. We regress the level of the term structure of inflation risk premia
against the spread between the level of the nominal and the real term struc-
ture, where the “level” is calculated, as above, by taking the average of

13
the one-, five- and ten-year maturity rates. Consistent with the evidence
presented in Evans (1998) for the U.K., we find that, in all the countries con-
sidered, inflation risk premia are significantly linked to the spread between
nominal and real interest rates. Therefore, a change in the difference between
nominal and real interest rates is only partially explained by a change in in-
flation expectations, as predicted by Fisher’s (1930) theory, the rest being
due to movements in inflation risk premia.
In panel B of table 6, we regress the volatility of the term structure of
inflation risk premia against the volatility of the term structure of real interest
rates and inflation expectations. We observe that the volatility of inflation
risk premia is mainly affected by the volatility of inflation expectations. This
is consistent with the evidence presented in Buraschi and Jiltsov (2005) for
the U.S., as it shows that the variability of inflation risk premia is essentially
due to monetary factors.

4.4 Implicit monetary policy rule

The model also provides endogenous estimates of the term structure of
actual output growth expectations over any time horizon (see equation (5)
above). Table 7 contains summary statistics on these estimates. We observe
that the average term structure of output growth expectations is upward
sloping and relatively steep in all countries, with the exception of the U.S.
In this case, the average term structure is flat around a relatively high level
(300 basis points) as an effect of the prolonged expansion experienced by the
U.S. over the sample period considered. Instead, the term structure of the
volatility of output growth rates is downward sloping for all the countries.
The correlation between the τ -maturity expected output growth rates
and the corresponding τ -maturity real interest rates and expected inflation
rates differs significantly across countries. In fact, both these correlations are
negative in the case of Japan, Germany and France and positive in the case
of the U.S., the U.K. and Italy.
Therefore, the sign of the estimated correlations is partially consistent
with the predictions of either the Mundell-Tobin or the Fama-Gibbons mod-
els. In the Mundell-Tobin framework an increase in expected inflation reduces
real interest rates and, in general, equilibrium expected real returns on fi-
nancial assets. This causes a decrease in the cost of capital and, therefore,
an impulse to capital investment and real economic activity. As a result, a
positive correlation between inflation and economic activity is implied by the
model. In contrast, the Fama-Gibbons model involves a negative correlation
between expected inflation and real activity, as it uses a monetary framework
which establishes a direct relation between demand for real money and real

14
activity so that an expected fall in real activity lowers the demand for real
money and, given nominal money and the current interest rate, requires a
rise in the price level for a new equilibrium to be reached.
Output growth expectations can be used, along with inflation expecta-
tions, to build a forward-looking Taylor rule explaining the movements of
the monetary policy short term interest rate. According to this model (see,
for example, Clarida, Galì and Gertler (2000) and Ang, Dong and Piazzesi
(2004)), the central bank sets short term interest rates in response to the
output growth and inflation rates expected over the next few months.
In order to test this hypothesis, we regress, for each country, the short
term monetary policy rate against the level of output growth and inflation
expectations. Moreover, we include among the regressors the slope of the
term structure of output growth and inflation expectations, which indicates
the expected trend in the macro variables.
As a proxy for the short term monetary policy rate we use the actual
three-month interest rate. The six-month horizon estimated expected output
growth and inflation rates and the difference between the three-year and the
six-month horizon expected output growth and inflation rates are used as
regressors10 .
Table 8 reports the estimation results. In all countries the explanatory
power of the regression is relatively high. In panel A of the table we ob-
serve that in the case of the U.S. and Japan, both the output and inflation
expectations appear to have an impact in influencing the monetary policy.
Instead, in the U.K., the monetary policy seems to move the short term in-
terest rate in response to a change in output growth expectations rather than
in inflation expectations.
As regards the EU countries, we divide the sample period into two parts
in order to take into account the fact that since 1999 they share a common
monetary policy, which is conducted by the European Central Bank. In
panel B of the table we notice that in the pre-99 period the monetary policy of
Germany, France and Italy is mainly focused on controlling inflation, whereas
in the post-99 period the monetary policy reaction function seems to be
mainly influenced by output growth expectations.
10
Using expectations estimated over different horizons, both for the level and the slope
of the term structure of output growth and inflation rates, does not change significantly
the results.

15
5 Conclusion
In this paper we have proposed a structural affine term structure model
which produces endogenous estimates for the term structures of real interest
rates, expected inflation rates and inflation risk premia by relying exclusively
on observations on nominal bond yields and macro variables.
The empirical analysis, which has been carried out for six countries, i.e.,
the U.S., the U.K., Japan, Germany, France and Italy, for the sample period
1991-2004, has provided reliable estimates of the implicit term structures of
real interest rates and inflation expectations and some new evidence on the
behaviour of inflation risk premia.
Moreover, by exploiting the model’s endogenous estimates of inflation
and output growth expectations, we have investigated the implicit monetary
policy reaction functions of the central banks.

16
 Appendix
This appendix provides the functional form of the coefficients in the closed
form solution of the theoretical model.

Equations (3-7)

AS (ω) ≡ Γ−1
S (BS (ω) − I) ΦS , BS (ω) ≡ exp(ωΓS )

CS (ω) ≡ − (Ψ − BS (ω)ΨBS (ω)0 )

AM (ω) ≡ ν − ΓM Γ−1 −1
S ΦS + BM (ω)ΓS ΦS
1
BM (ω) ≡ ΓM Γ−1 S (BS (ω) − I)
ω
à !
σ 2q /2
ν≡
−σ 2p /2

1 1
CM (ω) ≡ 2
ΓM Γ−1 −1 0 0
S CS (ω)(ΓS ) ΓM + ΓM Γ−1 −1 0 0
S ΣS ΣS (ΓS ) ΓM
ω ω
1 n o
− 2 ΓM ΓS ΓS (BS (ω) − I) ΣS ΣS + ΣS ΣS (BS (ω) − I)0 (Γ−1
−1 −1 0 −1 0 0
S ) (ΓS ) ΓM
ω
1h i
CSM (ω) ≡ CS (ω)(Γ−1 0 0 −1 −1 0 0
S ) ΓM − ΓS (BS (ω) − I) ΣS ΣS (ΓS ) ΓM
ω

Matrix Ψ is a function of the parameters in matrices ΓS and ΣS (See

Langetieg (1980, note 22)).

Equation (9)

1 e −1 h e −1 ³ e ´ i
κ0 (τ ) ≡ ε + β Γ S ΓS BS (τ ) − I − τ I (ΦS − ΣS Λ0 )
τ
τ ³ ´
e 0 (τ ) − 1 β Γ
− κ(τ )Ψκ e −1 Σ Σ Γ e −1 0 β 0
S S S S
2 · 2
1 ³ ´ ³ ´0 ³ ´ ³ ´¸
e e e e e e e −1 0 e −1 0
−1 −1
+ β ΓS ΓS BS (τ ) − I Ψ + Ψ BS (τ ) − I ΓS ΓS β0
2τ
1 e −1 ³ e ´
κ(τ ) ≡ β ΓS BS (τ ) − I
τ
e
ΓS ≡ ΓS − ΣS Λ1 , BeS (τ ) ≡ exp(τ Γ
e )
S

17
 ³ ´
β≡ 1 1 0 0 0 , ε ≡ −σ p (σ q ρ + σ p )

Matrix Ψ e is calculated as matrix Ψ above by substituting matrix Γ with

S
e
matrix ΓS .

Equation (10)

1 e −1 h e −1 ³ e ´ i
µ0 (τ ) ≡ αΓS ΓS BS (τ ) − I − τ I (ΦS − ΣS Λ0 )
τ
τ ³ ´
− µ(τ )Ψµe 0 (τ ) − 1 αΓe −1 Σ Σ Γ e −1 0 α0
S S
2 · 2 S S

1 ³ ´ ³ ´ ³ ´ ³ ´¸
+ α Γ e −1 Γ
e −1 B e (τ ) − I Ψe +Ψ e B e (τ ) − I 0 Γe −1 0 Γe −1 0 α0
S S S S S S
2τ
1 e −1 ³ e ´
µ(τ ) ≡ αΓS BS (τ ) − I
τ
³ ´
α≡ 1 0 0 0 0

18
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21
 Table 1
Parameter estimates

This table shows the parameter values of the state-space form (13-14) esti-
mated by the maximum likelihood - Kalman filter method. The sample period
is June 1991 to March 2004.

U.S. U.K. Japan

estimate std error estimate std error estimate std error

γ rr −0.7907 0.0400 −1.1132 0.0232 −0.4725 0.0707

γ πr −0.2506 0.0275 −0.4271 0.0407 −0.5002 0.0212
γ ππ −0.6042 0.0164 −0.3348 0.0261 −0.3956 0.0673
γ rr −0.7808 0.0394 −0.2859 0.0157 −0.4492 0.0247
γ πr 0.2053 0.0633 0.0401 0.0038 −0.1266 0.0084
γ ππ −0.1109 0.0161 −0.0103 0.0017 −0.2226 0.0305
γ xx −0.5740 0.0229 −0.6976 0.0488 −0.6314 0.1582
φr 0.0243 0.0018 0.0101 0.0007 0.0065 0.0037
φπ −0.0022 0.0025 −0.0022 0.0043 0.0046 0.0078
σr 0.0083 0.0040 0.0131 0.0013 0.0054 0.0041
σπ 0.0084 0.0003 0.0118 0.0002 0.0055 0.0023
σr 0.0261 0.0131 0.0149 0.0055 0.0095 0.0159
σπ 0.0099 0.0020 0.0083 0.0012 0.0141 0.0053
σx 0.0596 0.0146 0.0786 0.0288 0.1493 0.0021
σq 0.0188 0.0013 0.0366 0.0033 0.0638 0.0032
σp 0.0114 0.0008 0.0129 0.0005 0.0219 0.0016
ρ 0.0226 0.0362 0.2967 0.0121 −0.1937 0.0585
λ0r −0.0118 0.0230 −0.0667 0.0601 −0.0229 0.2819
λ0π −0.0129 0.0958 −0.0549 0.0729 −0.0424 0.1022
λ0r −0.0117 0.0413 −0.0277 0.0078 −0.0744 0.2200
λ0π −0.0069 0.2893 −0.0855 0.5316 −0.0868 0.8909
λrr 4.8099 1.6023 11.9492 1.0222 16.7068 0.2418
λπr 0.2322 0.6844 −0.0014 0.6313 0.0005 3.0053
λππ 34.6916 0.6453 16.3605 2.0112 21.8536 5.3011
λrr 0.8674 0.0697 −0.6919 0.0784 −1.0011 0.6505
λπr 5.7777 0.0483 −0.0039 0.3878 0.0013 0.1596
λππ −8.4756 0.0189 −1.2314 0.0043 −5.6285 0.3213

22
 Germany France Italy
estimate std error estimate std error estimate std error

γ rr −0.6532 0.0126 −1.5727 0.0173 −1.8118 0.0214

γ πr −0.3391 0.0058 −0.1909 0.0012 −0.0222 0.0077
γ ππ −0.4512 0.0013 −0.1693 0.0016 −0.4800 0.0147
γ rr −0.7515 0.0225 −0.4374 0.0161 −0.3412 0.0044
γ πr 0.0847 0.0072 0.1442 0.0032 0.0899 0.0025
γ ππ −0.1018 0.0162 −0.2148 0.0166 −0.0244 0.0107
γ xx −0.6649 0.1433 −0.5809 0.1039 −0.5495 0.0566
φr 0.0267 0.0005 0.0161 0.0002 0.0154 0.0062
φπ −0.0005 0.0002 −0.0009 0.0003 −0.0030 0.0004
σr 0.0059 0.0043 0.0197 0.0061 0.0214 0.0047
σπ 0.0041 0.0012 0.0077 0.0010 0.0110 0.0034
σr 0.0203 0.0056 0.0157 0.0054 0.0200 0.0020
σπ 0.0084 0.0034 0.0183 0.0041 0.0102 0.0047
σx 0.1279 0.0526 0.0822 0.0255 0.1047 0.0369
σq 0.0582 0.0033 0.0428 0.0024 0.0382 0.0024
σp 0.0223 0.0015 0.0126 0.0008 0.0069 0.0005
ρ −0.0516 0.0244 0.1141 0.0336 −0.1348 0.0438
λ0r −0.0556 0.0164 −0.0045 0.0267 −0.0125 0.0067
λ0π −0.0504 0.0211 −0.0237 0.0689 −0.0105 0.0387
λ0r −0.0759 0.0058 −0.0403 0.0066 −0.0154 0.2807
λ0π −0.0647 0.0072 −0.0336 0.0111 −0.0163 0.1462
λrr 1.4434 0.0053 −2.6965 0.0140 −5.6894 0.6745
λπr −2.5150 0.0051 0.0014 0.0063 −0.0007 0.1984
λππ −0.4375 0.0052 −1.4835 0.0173 −4.4781 1.1456
λrr −4.2765 0.0034 −3.0097 0.0197 −2.0102 0.2265
λπr 1.8201 0.0034 −0.0024 0.0147 −0.0019 0.4019
λππ −4.6813 0.0021 −3.9748 0.0134 −1.9804 0.4160

23
 Table 2
Estimation errors

Panel A of this table shows summary statistics on in-sample estimation errors

on bond yields and macro variables. An error is defined as the difference between
the fitted variable and its observed value and is measured in basis points. Mean
of the errors and root mean squared errors (RMSE) are calculated. The table
reports statistics both for on-the-run maturities (six-month, two-, five- and ten-
year rates) and off-the-run maturities (three-, four- and seven-year rates).
Panel B of the table shows the estimation results obtained by regressing
actual annualized logarithmic change in the IPI and the CPI between time
t and t + τ against their corresponding expectations generated by the model
estimates. β 1 is the slope coefficient of the regression. In parentheses, Newey-
2
West HAC standard errors. The table also provides the R of two benchmark
(bk) models: the Harvey model, where output growth rates realized between
time t and t + τ are regressed against the term spread observed at time t, and
the Fama-Mishkin model, where inflation rates realized between time t and t+τ
are regressed against the term spread observed at time t. The term spread is
calculated as the difference between the ten year and the two year interest rates.
The sample period is June 1991 to March 2004.

Panel A

U.S. U.K. Japan

Maturity Mean RMSE Mean RMSE Mean RMSE

6 months 0.03 0.94 0.03 1.23 0.04 2.68

2 years −0.05 2.11 −0.06 3.52 −0.05 3.48
5 years 0.02 2.95 0.04 4.38 0.02 3.87
10 years −0.01 2.26 −0.02 2.93 −0.01 3.27
3 years 0.08 2.47 −1.91 3.74 −0.29 3.32
4 years 0.31 3.00 −1.61 5.00 −0.64 3.96
7 years 0.35 2.29 1.25 3.29 −1.09 4.69

Germany France Italy

Maturity Mean RMSE Mean RMSE Mean RMSE

6 months 0.04 1.39 0.00 0.74 0.01 1.04

2 years −0.07 2.35 0.00 1.78 −0.02 2.73
5 years 0.03 3.00 0.00 2.15 0.01 3.04
10 years −0.01 2.22 0.00 1.48 −0.01 1.91
3 years 0.16 2.58 0.20 3.08 1.05 3.07
4 years −0.04 3.16 0.11 2.65 0.39 3.22
7 years −1.57 3.26 −1.38 3.43 −1.51 2.81

24
 Panel B

U.S. U.K. Japan

2 2 2 2 2 2
Time horizon β1 R R bk β1 R R bk β1 R R bk
IPI
3 months 1.07 0.96 0.00 1.33 0.80 0.03 1.14 0.87 0.03
(0.03) (0.09) (0.04)
6 months 0.94 0.87 0.00 0.89 0.67 0.10 0.95 0.82 0.04
(0.04) (0.05) (0.04)
1 year 0.77 0.60 0.00 0.74 0.52 0.16 0.63 0.43 0.04
(0.10) (0.09) (0.09)
CPI
3 months 1.36 0.61 0.00 1.32 0.70 0.01 1.21 0.31 0.00
(0.11) (0.07) (0.17)
6 months 1.14 0.75 0.00 1.05 0.76 0.00 1.05 0.53 0.00
(0.09) (0.06) (0.14)
1 year 0.70 0.50 0.00 0.60 0.47 0.09 0.84 0.62 0.00
(0.10) (0.09) (0.09)

Germany France Italy

2 2 2 2 2 2
Time horizon β1 R R bk β1 R R bk β1 R R bk
IPI
3 months 1.28 0.83 0.06 1.24 0.79 0.11 1.16 0.92 0.01
(0.07) (0.05) (0.03)
6 months 0.91 0.73 0.17 0.96 0.77 0.27 0.87 0.78 0.03
(0.05) (0.04) (0.04)
1 year 0.59 0.40 0.40 0.73 0.51 0.40 0.54 0.40 0.10
(0.11) (0.08) (0.08)
CPI
3 months 1.07 0.45 0.19 1.27 0.47 0.02 1.07 0.92 0.30
(0.24) (0.11) (0.03)
6 months 1.02 0.62 0.30 1.01 0.65 0.05 0.96 0.95 0.32
(0.18) (0.08) (0.03)
1 year 0.87 0.78 0.48 0.73 0.57 0.12 0.79 0.83 0.28
(0.07) (0.11) (0.05)

25
 Table 3
Real interest rates and expected inflation rates

This table shows summary statistics on the estimated term structures of

real interest rates and actual expected inflation rates. Data expressed in basis
points. The table also contains the correlation (in percentage terms) between
the τ -year maturity real interest rate and the corresponding τ -year maturity
expected inflation rate. The sample period is June 1991 to March 2004.

U.S. U.K.
Maturity Real rates Exp. Infl. Real rates Exp. Infl.
(years) mean s.d. mean s.d. corr. mean s.d. mean s.d. corr.

1 189 163 271 63 −4 362 150 265 87 −12

3 222 123 305 70 4 364 108 286 91 4
5 246 89 319 72 11 367 85 296 99 13
7 260 66 327 70 18 368 70 300 108 18
10 272 47 335 66 25 370 53 297 119 23
slope 83 117 64 43 −44 8 103 32 95 −55

Japan Germany
Maturity Real rates Exp. Infl. Real rates Exp. Infl.
(years) mean s.d. mean s.d. corr. mean s.d. mean s.d. corr.

1 98 103 30 88 38 272 103 197 113 78

3 98 69 60 111 22 309 81 195 107 60
5 108 51 84 122 10 339 62 195 106 48
7 118 40 100 123 4 359 48 195 103 43
10 129 29 113 113 0 378 34 197 97 40
slope 31 78 83 43 −49 106 72 0 61 57

France Italy
Maturity Real rates Exp. Infl. Real rates Exp. Infl.
(years) mean s.d. mean s.d. corr. mean s.d. mean s.d. corr.

1 337 205 170 60 34 372 259 309 133 67

3 352 147 182 71 57 402 206 304 156 85
5 368 111 190 81 66 424 164 300 174 89
7 380 87 196 87 70 439 133 299 186 91
10 391 64 200 89 73 454 101 298 196 92
slope 54 144 30 62 −73 82 162 −11 90 −91

26
 Table 4
Cross-country principal components analysis

This table summarizes the results of a cross-country analysis based on the

principal components technique. The analysis is applied to monthly changes in
the one-year, five-year and ten-year rates of the estimated term structures of
(i) nominal yields, (ii) real yields and (iii) expected inflation rates of the six
countries. The second column contains the proportion of the total variance of
the variables explained by each principal component (only the first four are re-
ported). The last six columns show, for each country, the average correlation
(calculated across the three maturities) with the estimated principal compo-
nents. We report only correlation coefficients above 50%. The sample period is
June 1991 to March 2004.

Prop. Cumul. Average correlation (%)

(%) (%) U.S. U.K. Japan Germany France Italy
Nominal Rates
I p.c. 50 50 63 76 86 81 73
II p.c. 17 67 75
III p.c. 10 77 52
IV p.c. 8 85 52

Real Rates
I p.c. 45 45 77 84 77 71
II p.c. 18 63 53 77
III p.c. 12 75 67
IV p.c. 8 83 53

Exp. Infl. Rates

I p.c. 46 46 66 67 86 85 54
II p.c. 15 61 80
III p.c. 10 71 55
IV p.c. 9 80 50

27
 Table 5
Inflation risk premia and expected excess bond returns

Panel A of this table contains summary statistics on the estimated inflation

risk premia included in the nominal term structure for different maturities.
Panel B of this table contains summary statistics on the estimated instanta-
neous expected excess returns on nominal zero coupon bonds, both aggregated
(total) and disaggregated with respect to each factor, i.e., the real interest rate
r, the expected inflation rate π and their central tendencies, r and π, respec-
tively. The expected excess returns are averaged across bond maturities (from
one to ten years).
All data are expressed in basis points. The sample period is June 1991 to
March 2004.

Panel A
U.S. U.K. Japan
Maturity (years) mean st. dev. mean st. dev. mean st. dev.
1 11 11 9 15 7 15
3 17 17 20 28 22 34
5 20 20 24 31 33 43
7 23 23 26 30 40 47
10 28 27 29 28 46 47
Germany France Italy
Maturity (years) mean st. dev. mean st. dev. mean st. dev.
1 −2 1 −1 1 1 2
3 6 3 4 1 4 3
5 12 6 11 5 7 3
7 17 9 17 10 9 7
10 23 13 25 16 9 14

Panel B
U.S. U.K. Japan
Factor mean st. dev. mean st. dev. mean st. dev.
r 0 5 0 6 −2 5
π 36 32 37 54 22 55
r −7 9 10 4 1 1
π 81 72 15 7 28 69
Total 110 96 61 57 49 118
Germany France Italy
Factor mean st. dev. mean st. dev. mean st. dev.
r 0 1 0 2 −1 13
π 0 3 −4 12 1 12
r 36 22 35 22 42 31
π 7 21 30 33 22 14
Total 43 23 61 40 64 34

28
 Table 6
Inflation risk premia determinants

Panel A of the table shows the estimation results of the following regression:
¡ ¢
IRP (t) = β 0 + β 1 · Y (t) − y(t) + e(t)

where IRP (t), Y (t) and y(t) denote the “level” of the term structure of inflation
risk premia, nominal rates and real rates, respectively, calculated by taking the
average of the one-, five- and ten-year maturity rates.
Panel B of the table shows the estimation results of the following regression:
¡ ¢
V IRP (t) = β 0 + β 1 · V (y(t)) + β 2 · V (π (t)) + e(t)
¡ ¢
where V IRP (t) is the volatility of the term structure of inflation risk premia
and V (y(t)) and V (π (t)) denote, respectively, the volatility of the real term
structure and the volatility of the term structure of expected inflation. The
volatility is calculated by taking the square root of the squared monthly changes
in the “level” series.
All coefficients and standard errors are multiplied by 100. In parentheses,
Newey-West HAC standard errors. The sample period is June 1991 to March
2004.

Panel A
U.S. U.K. Japan Germany France Italy

β0 −0.46 −0.22 0.03 −0.01 −0.04 −0.03

(0.08) (0.08) (0.02) (0.01) (0.01) (0.01)
β1 19.96 13.46 23.53 5.88 7.76 2.86
(2.31) (2.47) (1.31) (0.49) (0.54) (0.08)
2
R 0.69 0.34 0.87 0.88 0.82 0.96

Panel B
U.S. U.K. Japan Germany France Italy

β0 0.0000 0.0187 0.0084 0.0012 0.0018 0.0009

(0.0001) (0.0041) (0.0024) (0.0004) (0.0006) (0.0004)
β1 0.44 2.72 1.15 −0.29 0.42 0.19
(1.41) (2.08) (3.36) (0.42) (0.36) (0.22)
β2 8.03 5.27 18.99 6.24 5.11 2.68
(3.29) (1.80) (3.25) (0.42) (0.49) (0.36)
2
R 0.45 0.11 0.47 0.66 0.52 0.53

29
 Table 7
Output growth expectations

This table shows summary statistics on the estimated term structures of

actual expected output growth rates. The table also contains the correlation (in
percentage terms) between the τ -year horizon output growth expectation and
the corresponding τ -year maturity real interest rate (r) and expected inflation
rate (π). Data expressed in basis points. The sample period is June 1991 to
March 2004.

U.S. U.K. Japan

Horizon correl. correl. correl.
(years) mean s.d. r π mean s.d. r π mean s.d. r π

1 308 307 18 12 155 208 7 14 18 584 −25 −14

2 299 248 28 14 205 156 15 22 38 447 −22 −13
3 298 203 33 15 239 123 24 27 55 353 −18 −13
4 299 169 35 16 263 102 32 30 69 287 −15 −14
5 301 142 36 17 280 86 39 32 80 239 −13 −14

Germany France Italy

Horizon correl. correl. correl.
(years) mean s.d. r π mean s.d. r π mean s.d. r π

1 109 385 −34 −32 155 290 −34 −41 150 422 −1 15
2 163 291 −25 −26 197 228 −26 −36 208 342 9 23
3 203 228 −18 −22 229 183 −20 −31 252 281 16 28
4 232 185 −14 −20 254 151 −16 −26 285 236 22 31
5 255 153 −11 −18 273 127 −13 −23 310 201 25 34

30
 Table 8
Monetary policy response functions
This table shows the estimation results of the following regression:
M P R (t) = β 0 + β 1 · z1 (t) + β 2 · z2 (t) + β 3 · z3 (t) + β 4 · z4 (t) + e(t)
where M P R is the observed three-month nominal interest rate, which is a proxy
for the monetary policy rate, z1 is the six-month expected output growth rate,
z2 is the six-month expected inflation rate, z3 is the difference between the
three-year and the six-month expected output growth rates, z4 is the difference
between the three-year and the six-month expected output inflation rates. In
parentheses, Newey-West HAC standard errors.
Panel A of the table considers the sample period June 1991 to March 2004.
Panel B of the table considers the two sub-periods June 1991 to December 1998
and January 1999 to March 2004.

Panel A
U.S. U.K. Japan

β0 −0.013 0.010 −0.017

(0.007) (0.013) (0.004)
β1 1.369 1.124 1.875
(0.159) (0.301) (0.331)
β2 0.659 0.401 1.450
(0.257) (0.322) (0.221)
β3 3.151 2.099 4.004
(0.370) (0.546) (0.690)
β4 0.562 1.158 1.718
(0.508) (0.657) (0.426)
2
R 0.59 0.33 0.85

Panel B
pre-99 post-99
Germany France Italy Germany France Italy

β0 0.016 0.013 0.042 0.017 0.011 −0.007

(0.005) (0.008) (0.005) (0.007) (0.009) (0.012)
β1 0.139 0.064 −0.370 1.070 0.807 0.515
(0.135) (0.233) (0.233) (0.345) (0.265) (0.133)
β2 1.380 4.093 1.521 0.837 −0.366 0.895
(0.091) (0.516) (0.225) (0.541) (0.237) (0.619)
β3 0.335 0.401 −0.616 2.370 2.156 1.469
(0.272) (0.471) (0.548) (0.732) (0.624) (0.314)
β4 −1.102 −4.854 3.291 −0.588 0.171 0.484
(0.226) (1.282) (0.535) (0.597) (0.903) (1.091)
2
R 0.95 0.75 0.78 0.76 0.56 0.53

31
 Figure 1
Kalman filter estimates of the unobservable state variables
This figure shows the Kalman filter estimated series of the unobservable state
variables, i.e., the instantaneous real interest rate and expected inflation rate
and their time-varying central tendencies. The sample period is June 1991 to
March 2004.

U.S.
real interest rate
0.08
central tendency real interest rate
expected inflation rate
0.06 central tendency expected inflation r

0.04

0.02

-0.02

-0.04
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04
U.K.
0.1 real interest rate
central tendency real interest rate
expected inflation rate
0.08 central tendency expected inflation rate

0.06

0.04

0.02

0
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04

Japan

0.1 real interest rate

central tendency real interest rate
0.08
expected inflation rate
0.06 central tendency expected inflation rate

0.04

0.02

-0.02

-0.04
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04

32
 Germany

real interest rate

0.07
central tendency real interest rate
0.06 expected inflation rate
central tendency expected inflation rate
0.05

0.04

0.03

0.02

0.01

-0.01
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04
France

0.12 real interest rate

central tendency real interest rate
0.1 expected inflation rate
central tendency expected inflation rate
0.08

0.06

0.04

0.02

-0.02
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04

Italy

real interest rate

0.12
central tendency real interest rate
0.1 expected inflation rate
central tendency expected inflation rate
0.08

0.06

0.04

0.02

-0.02
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04

33
 Figure 2
Term structures
This figure shows the time series of the level, slope and curvature of the
estimated term structures of nominal, real and expected inflation rates. The
sample period is June 1991 to March 2004.

U.S.
Level
0.09
Nominal rates
0.08 Real rates
Expected inflation
0.07

0.06

0.05

0.04

0.03

0.02

0.01

0
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04
Slope
0.04
Nominal rates
Real rates
0.03
Expected inflation

0.02

0.01

-0.01
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04

Curvature
0.01
Nominal rates
Real rates
0.005
Expected inflation

-0.005

-0.01

-0.015

-0.02
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04

34
 U.K.

Level
0.12
Nominal rates

0.1 Real rates

Expected inflation

0.08

0.06

0.04

0.02

0
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04
Slope

0.04
Nominal rates

0.03 Real rates

Expected inflation
0.02

0.01

-0.01

-0.02

-0.03
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04

Curvature
0.02
Nominal rates
0.015 Real rates
Expected inflation
0.01

0.005

-0.005

-0.01

-0.015

-0.02
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04

35
 Japan

Level
0.08

0.07 Nominal rates

Real rates
0.06
Expected inflation
0.05

0.04

0.03

0.02

0.01

-0.01

-0.02
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04
Slope

0.04
Nominal rates
0.03 Real rates
Expected inflation
0.02

0.01

-0.01

-0.02

-0.03
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04

Curvature
0.015
Nominal rates

0.01 Real rates

Expected inflation

0.005

-0.005

-0.01

-0.015
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04

36
 Germany

Level
0.1
Nominal rates
0.09
Real rates
0.08
Expected inflation
0.07

0.06

0.05

0.04

0.03

0.02

0.01

0
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04
Slope

0.04
Nominal rates

0.03 Real rates

Expected inflation

0.02

0.01

-0.01

-0.02
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04

Curvature
0.015
Nominal rates

0.01 Real rates

Expected inflation

0.005

-0.005

-0.01

-0.015
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04

37
 France

Level
0.12
Nominal rates
0.1 Real rates

Expected inflation
0.08

0.06

0.04

0.02

0
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04
Slope

0.04

0.03

0.02

0.01

-0.01

Nominal rates
-0.02
Real rates
-0.03 Expected inflation

-0.04
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04

Curvature
0.02
Nominal rates
0.015
Real rates

Expected inflation
0.01

0.005

-0.005

-0.01

-0.015
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04

38
 Italy

Level
0.15

Nominal rates

0.12 Real rates

Expected inflation

0.09

0.06

0.03

0
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04
Slope

0.04

0.03

0.02

0.01

-0.01

-0.02
Nominal rates
-0.03
Real rates
-0.04 Expected inflation

-0.05
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04

Curvature
0.02
Nominal rates
0.015 Real rates
Expected inflation
0.01

0.005

-0.005

-0.01

-0.015
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04

39
 Figure 3
Inflation risk premia and expected bond excess returns
This figure shows the time series of the estimated inflation risk premia (IRP)
and instantaneous expected bond excess returns (EER), which are averaged
across maturities. Data expressed in basis points. The sample period is June
1991 to March 2004.

U.S.
100 400
1-year IRP
5-year IRP
75 10-year IRP 300
average EER (right scale)

50 200

25 100

0 0

-25 -100
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04
U.K.
120 1-year IRP 160

5-year IRP
10-year IRP
90 120
average EER (right scale)

60 80

30 40

0 0

-30 -40
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04

Japan
200 300
1-year IRP
250
150 5-year IRP
10-year IRP 200
average EER (right scale)
100 150

100
50
50

0 0

-50
-50
-100

-100 -150
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04

40
 Germany

60 1-year IRP 150

5-year IRP
10-year IRP

40 average EER (right scale) 100

20 50

0 0

-20 -50
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04
France

60 1-year IRP 150

5-year IRP
10-year IRP

40 average EER (right scale) 100

20 50

0 0

-20 -50
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04

Italy

60 1-year IRP 160

5-year IRP
10-year IRP
average EER (right scale)

30 80

0 0

-30 -80
Jun-91

Nov-92

Apr-94

Sep-95

Feb-97

Jul-98

Dec-99

May-01

Oct-02

Mar-04

41