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The Term Structure of Interest Rates, Real Activity and Inflation

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  • Philip Lowe

    (Reserve Bank of Australia)

Abstract

This paper examines, both theoretically and empirically, the relationship between the slope of the yield curve and future changes in real activity and inflation. It argues that the existence of sticky prices allows current and expected future monetary shocks to affect the slope of both the nominal and the real yield curves. Changes in real money balances brought about by monetary policy cause a strong liquidity effect at the short end of the yield curve. This results in changes in real output in the short/medium term which eventually get translated into changes in prices. The empirical results show that the spread between the 10 year Treasury bond and the 180 day bank bill predict the rate of change, over the subsequent one to two years, of a number of measures of real activity. Over both longer and shorter forecast horizons the spread has little predictive power. On the inflation front, the 10 year-180 day yield spread provides significant information about changes in inflation over the medium term (that is between one year and two and three years). Yield spreads between shorter dated securities are found to contain little information concerning future changes in inflation. This supports the view that at the shorter end of the yield curve changes in nominal rates often reflect changes in real rates.

Suggested Citation

  • Philip Lowe, 1992. "The Term Structure of Interest Rates, Real Activity and Inflation," RBA Research Discussion Papers rdp9204, Reserve Bank of Australia.
    • Handle: RePEc:rba:rbardp:rdp9204
    as

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    File URL: https://www.rba.gov.au/publications/rdp/1992/pdf/rdp9204.pdf
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    References listed on IDEAS

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    1. Frederic S. Mishkin, 1989. "A Multi-Country Study of the Information in the Term Structure about Future Inflation," NBER Working Papers 3125, National Bureau of Economic Research, Inc.
    2. Jeffrey A. Frankel & Cara S. Lown, 1994. "An Indicator of Future Inflation Extracted from the Steepness of the Interest Rate Yield Curve Along Its Entire Length," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 109(2), pages 517-530.
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    5. Newey, Whitney & West, Kenneth, 2014. "A simple, positive semi-definite, heteroscedasticity and autocorrelation consistent covariance matrix," Applied Econometrics, Russian Presidential Academy of National Economy and Public Administration (RANEPA), vol. 33(1), pages 125-132.
    6. Estrella, Arturo & Hardouvelis, Gikas A, 1991. "The Term Structure as a Predictor of Real Economic Activity," Journal of Finance, American Finance Association, vol. 46(2), pages 555-576, June.
    7. Mishkin, Frederic S., 1991. "A multi-country study of the information in the shorter maturity term structure about future inflation," Journal of International Money and Finance, Elsevier, vol. 10(1), pages 2-22, March.
    8. James H. Stock & Mark W. Watson, 1989. "New Indexes of Coincident and Leading Economic Indicators," NBER Chapters, in: NBER Macroeconomics Annual 1989, Volume 4, pages 351-409, National Bureau of Economic Research, Inc.
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    Cited by:

    1. Khurshid Kiani, 2011. "Fluctuations in Economic and Activity and Stabilization Policies in the CIS," Computational Economics, Springer;Society for Computational Economics, vol. 37(2), pages 193-220, February.
    2. Stephanos Papadamou, 2009. "Yield spreads and real economic activity in East European transition economies," Applied Economics Letters, Taylor & Francis Journals, vol. 16(5), pages 531-537.
    3. Valadkhani, Abbas, 2004. "Does the Term Structure Predict Australia's Future Output Growth?," Economic Analysis and Policy, Elsevier, vol. 34(2), pages 121-144, September.
    4. Joseph Atta-Mensah & Greg Tkacz, 1998. "Predicting Canadian Recessions Using Financial Variables: A Probit Approach," Staff Working Papers 98-5, Bank of Canada.
    5. David McMillan, 2002. "Interest rate spread and real activity: evidence for the UK," Applied Economics Letters, Taylor & Francis Journals, vol. 9(3), pages 191-194.
    6. J.D. Hollingworth, 1997. "Leading Indicators of Australian Recessions: Part 2," Economics Discussion / Working Papers 97-17, The University of Western Australia, Department of Economics.
    7. Tony Makin, 1998. "A New Rule for Monetary Policy," Agenda - A Journal of Policy Analysis and Reform, Australian National University, College of Business and Economics, School of Economics, vol. 5(1), pages 17-24.
    8. Malcolm Edey & John Romalis, 1996. "Issues in Modelling Monetary Policy," RBA Research Discussion Papers rdp9604, Reserve Bank of Australia.
    9. Chay Fisher & Bruce Felmingham, 1998. "The Australian yield curve as a leading indicator of consumption growth," Applied Financial Economics, Taylor & Francis Journals, vol. 8(6), pages 627-635.
    10. Nicolas de Roos & Bill Russell, 1996. "Towards an Understanding of Australia’s Co-movement with Foreign Business Cycles," RBA Research Discussion Papers rdp9607, Reserve Bank of Australia.
    11. Daniel Daugaard & Tom Valentine, 1993. "Bank Share Prices and Profitability," Working Paper Series 31, Finance Discipline Group, UTS Business School, University of Technology, Sydney.
    12. A. Mansur & M. Masih & Vicky Ryan, 2005. "The term structure of interest rates in Australia: an application of long run structural modelling," Applied Financial Economics, Taylor & Francis Journals, vol. 15(8), pages 557-573.

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