Real Risk, Inßation Risk, and the Term Structure

I develop and estimate a general equilibrium model for the term structures of nominal and real interest rates in the UK that incorporates Markov-switching. The model allows for nonneutralities, nonlinear dynamics, and ßexibility in the dynamics of the risk premia features that are all present in the data. I use the model to assess how accurately the term structure reßects changing expectations of future yields and inßation. This analysis shows that the presence of time-varying risk premia make it very hard to accurately track changes in the expected path of real or nominal yields over horizons of less than Þve years. By contrast, variations in inßation expected over the next two to three years are very accurately reßected by changes in spread between real and nominal yields, or by changes in nominal yields alone. Over longer horizons, the term structures closely track changing expectations regarding future nominal and real yields but not future inßation.