Monetary policy and the term structure of interest rates in a small open economy - a model framework approach

Using a simple single-equation approach, many studies have shown that the term structure of interest rates or its approximation – the term spread is a potentially useful indicator of future inflation and/or future real economic activity. We argue that these results may be biased due to the insufficiencies of the single-equation approach and that the predictive ability must be analyzed from within a model framework. Simple general equilibrium macroeconomic model of a small open economy is introduced and the indicative properties of the term structure are discussed from within its framework. Our main contribution to the literature is threefold. First, we show that the predictive ability of the term spread is not structural but monetary policy dependent. Second, we argue that the term spread's predictive ability with regard to future inflation (real economic activity) increases with increasing weight on inflation (real economic activity) stabilization in central bank's reaction function. Third, we show that undestanding the way expectations are formed is an important prerequisite for using the term structure as an indicator for monetary policy. Apart from these general findings, the predictive power of the term spread is examined in the case of the Czech economy. It is shown that the term spread between one year and three month PRIBOR interest rates of one percentage point indicates that agents expect inflation to be almost one percentage point above the target six quarters ahead.