The inflation risk premium in the term structure of interest rates bis quarterly Review, part 3, September 2008

t

x

 – ie the deviation of actual output from 

“potential” (efficient) output – is assumed to depend on expectations of the output gap in the future, on 

the lagged output gap, and on the next period’s expected short-term real interest rate (nominal rate 

t

r

 

minus expected inflation rate 

[ ]

1

+

π

t

t

E

): 

[ ]

(

)

[ ]

(

)

x

t

t

t

t

r

t

x

t

t

x

t

E

r

x

x

E

x

ε

+

π

−

ζ

+

μ

−

+

μ

=

+

−

+

1

1

                               (3) 

The leads and lags of the output gap can be thought of as capturing consumption smoothing 

behaviour and consumption habits, respectively, among investors (consumption is equal to output 

in standard simple models). The presence of the expected real rate in (3) allows consumption to 

shift over time in response to interest rate movements. The last term is a demand shock (eg a 

preference shock). Inflation is specified in a similar fashion, with expected future inflation as well 

as lagged inflation included to capture price stickiness and inflation inertia: 

[ ]

(

)

π

−

π

+

π

ε

+

δ

+

π

μ

−

+

π

μ

=

π

t

t

x

t

t

t

t

x

E

1

                                    (4) 

In addition, the output gap enters the inflation equation, so that, for example, positive 

demand shocks that push output above potential can have inflationary consequences (in a 

microfounded model, this term would arise because monopolistic competition implies that prices 

will be set as a markup on marginal cost). Inflation is also assumed to be affected by supply 

shocks, 

π

ε

t

, such as oil price shocks and other so-called cost push shocks.  

With the specification of output and inflation in place, the final building block specifies how 

monetary policy is conducted. Specifically, it is assumed that a forward-looking Taylor (1993) rule 

is capable of describing how the central bank sets the short-term nominal interest rate: 

[ ]

(

)

r

t

t

t

*

t

t

t

t

r

x

E

r

ε

+

ρ

+

γ

+

π

−

π

β

=

−

+

1

                                       (5) 

According to this rule, the policy rate depends on whether inflation is higher or lower than the 

level targeted by the central bank (