The Effects of Inflation Uncertainty on Interest Rates: a Nonlinear Approach

Abstract

In this article, we investigate the effects of inflation variability on short-term interest rates within a nonlinear smooth transition regression framework. The test results suggest that only the conditional mean of the inflation is a nonlinear process whereas the conditional variance is time variant but linear. Using the square root of conditional variance as a proxy for inflation risk, we estimate Fisher equation augmented with inflation risk. Although the estimated Fisher equations suggest that inflation risk reduces short-term interest rates, we find that the effects of inflation risk on interest rates are regime-dependent. Particularly, we find that the negative effects of inflation variability on nominal rates are greater in low-inflationary regimes when compared to high-inflationary regimes. On the other hand, it is found that both inflation and inflation uncertainty raise the expected inflation effect.