Do term premiums matter? Transmission via exchange rate dynamics

BIS Working Papers  |  No 971  | 
27 October 2021



Using a small open economy model with long-term bonds, we ask whether term premia affect the inflation rate and the economy via the exchange rate. We focus in particular on the observation that uncovered interest rate parity holds better for long-term interest rate differentials. As term premia are the gap between long-term interest rates and the future path of short-term interest rates, this observation suggests that changes in term premia may influence the exchange rate and thus affect inflation and the real economy.


To account for the uncovered interest rate parity observation, we make two assumptions. First, that households do not invest in foreign bonds and save only by investing in domestic short- and long-term bonds. Second, that bond investors do not trade short-term domestic and foreign bonds but only long-term domestic and foreign bonds. These lead to two consequences: first, they make the model consistent with the observation for uncovered interest rate parity. Second, they allow term premia to influence inflation and the real economy via exchange rate changes.


We estimate the model parameters using data for the Japanese and US economies. We find that the decline in US term premia put downward pressure on the Japanese inflation rate through the yen's appreciation against the US dollar since 2008. However, since 2013, the fall in Japan's term premia, induced by the Bank of Japan's easing policy, has raised inflation by weakening the exchange rate. Hence, the quantitative results imply that the exchange rate has been affected by both US and Japanese term premia, leading to appreciable effects on Japan's inflation.


The macroeconomic effect of term premiums is a controversial issue both theoretically and quantitatively. In this paper, we explore the possibility that term premiums affect inflation and the real economy via exchange rate dynamics. For this purpose, we construct a small open economy model with limited asset market participation, focusing on the empirical observation that uncovered interest parity holds better for longer-term interest rate differentials. A quantitative exercise using Japanese and U.S. data shows that changes in term premiums, particularly those made by the central bank's bond purchases, have sizable effects on Japanese inflation rates via exchange rate dynamics.

Keywords: term premium, uncovered interest rate parity, quantitative easing.

JEL classification: E31, E52, E58.