The missing link between inflation uncertainty and interest rates

Abstract

In the literature, there is no consensus about the direction of the effects of inflation uncertainty on interest rates. This paper states that such a result may stem from differentiation in the sources of the uncertainties and analyzes the effects of different types of inflation uncertainties on a set of interest rates for the UK within an interest rate rule framework. Three types of inflation uncertainties - impulse uncertainty, structural uncertainty and steady-state uncertainty - are derived by using a time-varying parameter model with a Generalized Autoregressive Conditional Heteroskedasticity specification. It is shown that the impulse uncertainty is positively and the structural uncertainty is negatively correlated with the interest rates. Moreover, these two uncertainties are important to explain short-term interest rates for the period of inflation targeting era. However, this time, the impulse uncertainty is negatively and the structural uncertainty is positively correlated with the overnight interbank interest rates, which is consistent with the general characteristic of the inflation targeting regimes. Lastly, the evidence concerning the effect of the steady-state inflation uncertainty on interest rates is not conclusive. © Scottish Economic Society 2005.