An Empirical Investigation of Bond Prices and Inflation

George Pennacchi

Rodney L. White Center for Financial Research Working Papers from Wharton School Rodney L. White Center for Financial Research

Abstract: This paper investigates the dynamics of real interest rates and inflation in the context of an equilibrium asset pricing model. Formulas for bond prices and optimal forecasts of inflation are shown to form a state space system. The model’s parameters are estimated by maximum likelihood, using a Kalman filter to compute the likelihood function. The estimation uses time series data on Treasury bill prices of various maturities and survey forecasts of inflation. The results suggest chat the stochastic processes for real interest rates and expected inflation are mutually dependent; innovations in the processes display significant negative correlation while expected changes in each variable are significantly positively related to the level of the other variable. There is evidence that over the past decade inflation and real interest rates have displayed somewhat less mean reversion than previously. Distinguishing real rates from expected inflation is likely to lead to gains in interest rate modelling.

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Persistent link: https://EconPapers.repec.org/RePEc:fth:pennfi:17-88

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