Research Discussion Paper – RDP 2018-02 Affine Endeavour: Estimating a Joint Model of the Nominal and Real Term Structures of Interest Rates in Australia

We outline a ‘workhorse’ affine term structure model of nominal and real interest rates in Australia. The model allows us to decompose observed yields paid on nominal and inflation-indexed government bonds into expectations for real and nominal interest rates, expectations for inflation, as well as real term premia and inflation risk premia. The results should not be interpreted too precisely given data limitations and the complexity of the model. Nevertheless, they suggest that medium- to long-term expectations for real interest rates, a market-based measure of the neutral real interest rate, have declined in recent years. At the same time, long-term inflation expectations have remained firmly within the Reserve Bank's 2 to 3 per cent target band and have been more stable than suggested by measures of break-even inflation. Finally, the results suggest that real term premia have declined since the global financial crisis, which may reflect overseas factors given it has coincided with declines in US term premia.