THE SHADOW DEFAULT-FREE REAL RATE OF RETURN

This paper attempts to resolve several intriguing observations. First, there is an unusually high correlation between the inflation-protected and nominal interest rates when the changes in the nominal interest rates are predominantly driven by inflationary pressure. This observation appears to contradict the Fisherian paradigm and the neo-Keynesian reasoning regarding the neutrality of monetary policy and real interest rates. Stiglitz (1983) argued that in the absence of intergenerational distribution effects, public financial policy has neither real nor financial effects on the optimal mixture of nominal and inflation-protected instruments. Second, a modest increase in the Break-Even Rate (BER) relative to a recent rise in expected inflation implies a lower Inflation Risk Premium (IRP) in a period with higher uncertainty about inflation. Third, the non-monotonic pattern of the volatilities of the default-free interest rates, where the volatility declines over maturity for the long-duration bonds. These observations may cast doubt on whether the default-free inflation-protected bond yields represent the real rates. This paper proposes to define a new concept of the shadow default-free real rate of return, derived directly from the market's equity and debt yields. The paper tests and confirms the hypothesis that this shadow rate of return is uncorrelated with the default-free nominal interest rates, highly correlated with changes in real GDP, and exhibits a monotonic volatility structure over maturity.