DP13388 Real Interest Rates, Inflation, and Default

Author(s): Sewon Hur, Illenin Kondo, Fabrizio Perri
Publication Date: December 2018
Date Revised: December 2018
Keyword(s): Government Debt, Inflation risk, nominal bonds, sovereign default
JEL(s): E31, F34, G12, H63
Programme Areas: International Macroeconomics and Finance, Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13388

This paper argues that the comovement between inflation and economic activity is an important determinant of real interest rates over time and across countries. First, we show that for advanced economies, periods with more procyclical inflation are associated with lower real rates, but only when there is no risk of default on government debt. Second, we present a model of nominal sovereign debt with domestic risk-averse lenders. With procyclical inflation, nominal bonds pay out more in bad times, making them a good hedge against aggregate risk. In the absence of default risk, procyclical inflation yields lower real rates. However, procyclicality implies that the government needs to make larger (real) payments when the economy deteriorates, which could increase default risk and trigger an increase in real rates. The patterns of real rates predicted by the model are quantitatively consistent with those documented in the data.