Term structure, inflation and real activity

This paper presents and estimates an internally consistent struc- tural model which imposes cross-sectional restrictions on the dynamics of the term structure of interest rates, inflation and output growth. Distinct from previous term structure settings, this model introduces both time-varying central tendencies and a stochastic conditional mean of output growth. The estimation of the model, which is based on U.S. data over the 1960 to 2005 sample period, provides reliable estimates for the implicit term structures of real interest rates, expected inflation rates and inflation risk premia and for the expectations of macroeconomic variables. The model has better out-of-sample forecasting properties than a number of competitors and contradicts the puzzling evidence that during the “Great Moderation” in inflation subsequent to the mid-Eighties the forecasting ability of structural models has deteriorated with respect to atheoretic statistical models.