The effect of different inflation risks on interest rates of the US

Abstract

This article examines the effect of different inflation uncertainty measures on interest rates of the US in a Fisher hypothesis framework. Generalized Autoregressive Conditional Heteroskedasticity (GARCH) specification with a time-dependent parameter model is used to obtain three types of inflation uncertainties, namely, impulse uncertainty, structural uncertainty and steady-state uncertainty. It has been observed that the impulse uncertainty has negative but the structural uncertainty has positive impact on both short-term and long-term interest rates. Both of these effects are statistically significant. The influence of steady-state uncertainty on interest rates is positive, but the level of significance depends on the inclusion of output gap. Without the inclusion of output gap, the effect is insignificant, whereas the effect becomes significant when output gap is introduced.

Acknowledgements

We thank Zubeyir Kilinc for providing computer programming codes and for his feedback and Anita Akkas for her contributions.

Notes

¹ See Cukierman and Wachtel (1979), Cukiermen and Meltzer (1986), Ball and Cecchetti (1990), Evans (1991), Ball (1992), Evans and Wachtel (1993), Holland (1993, 1995) and Chen et al. (2006) for the positive relationship between inflation risk and inflation; Hafer (1986) and Holland (1986) for the negative correlation between inflation risk and employment; Friedman (1977), Froyen and Waud (1987) and Holland (1988) for the negative association between inflation risk and output; Al-Marhubi (1998) for the negative relationship between inflation volatility and mean growth; Lee and Ni (1995) for the negative correlations between inflation uncertainty and real economic activity; Zandamela (1989) for the impact of inflation uncertainty on wage indexation.

² See Fama (1975), Fama and Gibbons (1982), Mishkin (1992) and Mishkin and Simmons (1995).