Term Structure of Real Rates and Expected Inflation
Changes in nominal interest rates must be due to either movements in real interest rates,expected inflation, or the inflation risk premium. We develop a term structure model withregime switches, time-varying prices of risk, and inflation to identify these components of thenominal yield curve. We find that the unconditional real rate curve is fairly flat at 1.44%, butslightly humped. In one regime, the real term structure is steeply downward sloping. Real rates(nominal rates) are pro-cyclical (counter-cyclical) and inflation is negatively correlated with realrates. An inflation risk premium that increases with the horizon fully accounts for the generallyupward sloping nominal term structure. We find that expected inflation drives about 80% of thevariation of nominal yields at both short and long maturities, but during normal times, all of thevariation of nominal term spreads is due to expected inflation and inflation risk.