Core and “crust”: Consumer prices and the term structure of interest rates. Working Paper, Federal Reserve Bank of Chicago

We propose a model for nominal and real term structures of interest rates that includes dynamics for the three main components of total inflation: core, food, and energy. These dynamics combine together to produce a measure of expected total inflation that investors use to price nominal Treasuries. This framework captures different frequencies in inflation fluctuations: shocks to core are more persistent and less volatile than shocks to food and, especially, energy (the ‘crust’). We find that a common structure of latent factors determines and predicts the term structure of yields and inflation. Our model outperforms popular benchmarks, e.g., ARMA, VAR, and random walk specifications, and it is at par with the Survey of Professional Forecasters in forecasting inflation. Moreover, we estimate real rates that agree with inflation-indexed bond yields after adjusting for the liquidity premium in these bonds. Finally, inflation and real rate risk premia show a declining pattern consistent with the changing nature of inflation and real rate risks