How large is the inflation risk premium in the U.S. nominal term structure?

Finance

IFA Working Paper

2000

This paper is an empirical study on the inflation risk premium in the nominal term structure of interest rates. We consider a general equilibrium production economy in which (i) the monetary policy is responsive to both nominal and real shocks, (ii) the stochastic process for inflation is endogenous, (iii) taxes are paid on nominal profits and the fiscal system is allowed to be only partially indexed to inflation shocks. The distortionary impact of inflation generates the potential existence of a risk premium on the inflation rate. (iv) In addition to nominal shocks, the stochastic investment opportunity set is affected by multiple real factors. We obtain analytical solutions for the equilibrium term structure of nominal and real interest rates. Moreover, we compute closed-form solutions for the risk premium on the inflation rate. In the econometric section, we estimate the monetary model using a dataset on all US Treasury bonds traded between 1960 to 1996. We estimate the risk premium on the inflation rate and formally test the Fisher hypothesis. Second, we discuss a specification test for the number of factors in the monetary term structure model that explicitly addresses the well known stochastic singularity problem that affects likelihood-based test when applied to state-space models. Moreover, we measure the extent of time variation of risk premia on nominal (monetary) shocks with respect to real (technological) shocks. The results shed some light on whether the rejection of the expectation hypothesis is due mainly to the time variation of the risk premium on nominal shocks, the risk premium on the real factors or both.

Institute of Finance and Accounting

FIN 307

IFA Working Paper

No