Interest Rates and Inflation Revisited

Abstract

The continuously compounded (CC) interest rate on a one-month Treasury bill observed at the end of month t-1 is the sum of a CC expected real return and a CC expected inflation rate, Rt-1 = Et-1(rt) + Et-1(It). Two approaches are used to split Rt-1 between its two components. In the first, models for rt produce estimates of Et-1(rt), which are used to infer Et-1(It) as Rt-1 - Et-1(rt). The second approach models It to produce estimates of Et-1(It) and infer Et-1(rt) as Rt-1 - Et-1(It). By design, the estimates of Et-1(rt) and Et-1(It) from both approaches have the properties implied by rational bill prices. Received October 10, 2018; Editorial decision December 31, 2018 By Editor Jeffrey Pontiff.