Treasury Bills, Bonds And Sector Inflation Indices: A Spectral Analysis

Abstract

This paper uses spectral and correlation techniques to analyze the relationship between several inflation indicators and nominal interest rates. Empirical definitions of real interest rates reduce to stating real rates are equal to nominal interest rates minus expected inflation. To represent a number for inflation, economy-wide measures such as the GDP deflator or the Consumer Price Index are employed. This uncritical usage results more often than not in implausible values for real interest rates. In particular, volatile negative real rates are encountered for prolonged periods ranging from six months to up to three years. Such long time intervals for negative real rates amounts to accepting the unrealistic proposition that profit maximizing lenders, such as commercial bank officers, pay hefty fees to borrowers to have them use their institution's loanable funds. This paper questions the effectiveness of GDP or CPI inflation measures in surrogating for expected inflation. We find instead that narrower sector (industry) inflation indices such as fuels or raw materials prices appear to be improved measures. The issue matters since accurate real interest rate estimates are necessary for policy (Taylor rules), financial model evaluation, and discounting.