Core and ‘Crust’: Consumer Prices and the Term Structure of Interest Rates

We propose a no-arbitrage model of the nominal and real term structures that accommodates the different persistence and volatility of distinct inflation components. Core, food, and energy inflation combine into a single total inflation measure that ties nominal and real risk-free bond prices together. The model successfully extracts market participants’ expectations of future inflation from nominal yields and inflation data. Estimation uncovers a factor structure common to core inflation and interest rates and downplays the pass-through effect of short-lived food and energy shocks on inflation and interest rates. Model forecasts systematically outperform survey forecasts and other benchmarks.Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.