Beliefs About Inflation and the Term Structure of Interest Rates

47 Pages Posted: 12 Jun 2012

See all articles by Philipp K. Illeditsch

Philipp K. Illeditsch

Texas A&M University - Mays Business School - Finance Department

Michael F. Gallmeyer

University of Virginia (UVA) - McIntire School of Commerce

Christian Heyerdahl-Larsen

Indiana University - Kelley School of Business - Department of Finance

Paul Ehling

BI - Norwegian Business School

Date Written: June 2012

Abstract

We study how differences in beliefs about expected inflation affect the nominal term structure when investors have “catching up with the Joneses” preferences. In the model, “catching up with the Joneses” preferences help to match the level and slope of yields as well as the level of yield volatilities. Disagreement about expected inflation helps to match the dynamics of yields and yield volatilities. Expected inflation disagreement induces a spillover effect to the real side of the economy with a strong impact on the real yield curve. When investors share common preferences over consumption relative to the habit with a coefficient of relative risk aversion greater than one, real average yields across all maturities rise as disagreement increases. Real yield volatilities also rise with disagreement. To develop intuition concerning the role of different beliefs between investors, we consider a case where the real and nominal term structures can be computed as weighted-averages of quadratic Gaussian term structure models. We numerically find increased disagreement about expected inflation between the investors increases nominal yields and nominal yield volatilities at all maturities. We find empirical support for these predictions.

Suggested Citation

Illeditsch, Philipp K. and Gallmeyer, Michael F. and Heyerdahl-Larsen, Christian and Ehling, Paul, Beliefs About Inflation and the Term Structure of Interest Rates (June 2012). Jacobs Levy Equity Management Center for Quantitative Financial Research Paper , Available at SSRN: https://ssrn.com/abstract=3689920 or http://dx.doi.org/10.2139/ssrn.3689920

Philipp K. Illeditsch (Contact Author)

Texas A&M University - Mays Business School - Finance Department ( email )

Wehner Building 351Q
4113 TAMU | 210 Olsen Blvd
College Station, TX Brazos County 77843-4218
United States

HOME PAGE: http://https://sites.google.com/view/philippilleditsch

Michael F. Gallmeyer

University of Virginia (UVA) - McIntire School of Commerce ( email )

P.O. Box 400173
Charlottesville, VA 22904-4173
United States
434-243-4043 (Phone)
434-924-7074 (Fax)

HOME PAGE: http://www.commerce.virginia.edu/faculty_research/facultydirectory/Pages/Gallmeyer.aspx

Christian Heyerdahl-Larsen

Indiana University - Kelley School of Business - Department of Finance ( email )

1309 E. 10th St.
Bloomington, IN 47405
United States

Paul Ehling

BI - Norwegian Business School ( email )

N-0442 Oslo
Norway
+47 46410505 (Phone)

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