Non-Linear Dynamics of Yield Spreads and Inflation: Evidence from India

Abstract

Inflation expectations hold utmost importance in central bank policymaking as they serve as a critical determinant of economic stability and the effectiveness of monetary policy measures. Based on this motivation, this study empirically examines the information content of yield spreads across different time horizons, using a Fisher equation-based model, to explain future changes in inflation. Interestingly, linear specifications fail to capture the relationship between yield spreads and inflation changes. To address this limitation, we employ a threshold model that reveals a significant non-linear association between yield spreads and inflation, particularly over longer time horizons in India. Out of sample forecasting results obtained further confirm that non-linear models are better fit compared to linear models to estimate the future changes in inflation. By embracing a non-linear approach, this study enhances our understanding of the complex dynamics between yield spreads and inflation in India, providing valuable insights for policymakers and economists alike.