Term Structures of Inflation Expectations and Real Interest Rates: The Effects of Unconventional Monetary Policy



Managing inflation expectations is an important part of the Federal Reserve's monetary activities. Inflation expectations affect the real yield curve – the inflation-adjusted schedule of interest rates over time – which in turn affects the quantity of loans issued and investments made. During the Great Recession, the Federal Reserve sought to reduce long-term interest rates, relying on unconventional monetary policy techniques because short-term interest rates were already at the zero lower bound and could not be lowered any further. Significant public debate has since ensued about just what effect the Federal Reserve's unprecedented policies will have on inflation, with some fearing that runaway inflation may be around the corner. Aruoba combines data on inflation expectations from a number of different surveys in order to construct a term structure of expected inflation for horizons from 3 to120 months. Aruoba tests the constructed inflation expectations measure against actual inflation data from 1992 to 2013. He also uses this measure to examine the effect of the Federal Reserve's unconventional monetary policy on inflation expectations and the real yield curve.

Aruoba’s inflation expectations measure yields a robust forecast of inflation, outperforming measures drawn from single surveys and from models relying on financial variables. With a reliable measure in hand, Aruoba first examines the effect of the 2008 financial crisis on inflation expectations. While short- to medium-run inflation expectations fell, long-run inflation expectations remained anchored throughout the crisis. Examining the Federal Reserve's unconventional monetary policies, Aruoba finds that Quantitative Easing 1 and 2 both increased expected inflation for the short to medium term, but not for the long run. Meanwhile, Operation Twist did not affect inflation expectations, though it did reduce long-term interest rates. All in all, the Federal Reserve's efforts resulted in about a 3.5 percentage point reduction in real interest rates at all horizons, with the entire real yield curve falling below zero starting in September of 2011.

Aruoba's analysis suggests that, during the crisis, the Federal Reserve successfully provided a large degree of monetary stimulus to the economy while keeping long-run inflation expectations anchored. His findings are not consistent with concerns that the Federal Reserve's unconventional monetary policies have set the stage for accelerating inflation, suggesting instead that these policies largely achieved their objectives without triggering expectations of hyperinflation. Aruoba's measure of the term structure of inflation should be of considerable value to policy makers for future use in managing inflation expectations, forecasting future inflation rates, and understanding the real yield curve.