Abstract: Many pricing models imply that nominal interest rates contain information on inflation expectations.
This has lead to a large empirical literature
that investigates the use of interest
rates as predictors of future inflation.
Most of these focus on the Fisher hypothesis in which the interest rate maturity matches the inflation horizon.
In general forecast improvements have been modest and often fail to improve on autoregressive benchmarks.
Rather than use only monthly interest rates
that match the maturity of inflation, this paper advocates using the whole term structure of daily interest rates and their lagged values to forecast monthly inflation. Principle component methods are employed to combine information from interest
rates across both the term structure and time series dimensions.
We find robust forecasting improvements in general as compared to both an augmented Fisher equation and autoregressive benchmarks.
Keywords: inflation, inflation forecast, Fisher equation, term structure, principal components
JEL Classification: E31;E37;C53;C32