Decomposing the Term Structure of Interests Rates: Evidence from a Small Open Economy

Abstract

This paper uses Israeli data of inflation-indexed and nominal government bonds to estimate a discrete-time essentially affine term structure model. To estimate the model, I use a uniquely long-spanned sample of monthly real yields for the period of 01/1985-03/2018. The nominal yields data spans the period of 05/2001-03/2018. I document an unconditional upward sloping real term structure that the model ascribes to a rising real term premium while the average expected real short rates are relatively flat. A decomposition of the break-even inflation shows that the unconditional term structure of the inflation premium is increasing with maturity and most of the variance in the short end is due to expected inflation. However, in the long end, most of it is due to the inflation term premium.

Keywords: Affine term structure models, Inflation-indexed bonds, Israel, Inflation, Monetary policy

JEL Classification: G12, E43, E44, E52