Evidence for 'Flight to Quality' hypothesis within an inflation uncertainty modelling

Abstract

There is a great literature devoted to link between inflation uncertainty and interest rates. However, there are opposing findings about the relationship between inflation uncertainty and interest rates. Some of the studies find a positive correlation between them, while some of them find a negative correlation. In this paper, we analyzed the link between inflation uncertainty and spreads among riskier and safer bonds within a model of a timevarying parameter model with an ARCH specification. We divided inflation uncertainty into two parts, structural uncertainty and impulse uncertainty, as indicated in Evans (1991), firstly. We estimated the relationship between these types of uncertainties and spreads among riskier and safer bonds, using USA data. The results indicate us that both structural and impulse uncertainties have significant relationship with spreads between corporate bonds, the riskier bonds, and treasury bills, the safer bonds. Especially having a positive effect of impulse uncertainty on spreads shows an important evidence for ‘Flight to Quality’ hypothesis.