[2022-7] Asymmetrical Effects of U.S. Inflation Expectations & Term Premium on Korea's Yield Curve

Articles in Monthly Bulletin
Research Department(02-759-4150)

Financial market volatility has been expanding recently as inflation expectations and long-term interest rates in major countries have risen due to ongoing high inflation worldwide. This is expected to affect Korea's yield curve through various channels. This paper analyzes the effects of U.S. inflation expectations and its term premium on Korea’s yield curve, focusing on the channels through which the yield curves of emerging market countries synchronize with those of advanced countries: the monetary policy channel, the inflation expectations channel, and the term premium channel. This is based on the expectations hypothesis and the liquidity preference hypothesis. Considering the enhanced accuracy of analysis and the recent global inflation surge, the economic regime is divided into high inflation periods (Jan. 2001-June 2010, March 2021-March 2022) and a low inflation period (July 2010-Feb. 2021), based on the level and volatility of U.S. inflation. The Dynamic Nelson-Siegel model is used to examine whether U.S. inflation expectations and term premiums affect Korea’s yield curve, and whether their impact is asymmetrical depending on economic regime.


The results of the estimation show that U.S. inflation expectations alone have a statistically significant effect on Korea’s yield curve during the periods of high U.S. inflation, while the U.S. term premium shock is statistically strongly significant during the low inflation period. During the high inflation periods, the shorter the maturity, the larger impact the U.S. inflation expectation shock, leading to a flattening of the yield curve. During the low inflation period, the longer the maturity, the larger impact the U.S. term premium shock has, causing the yield curve to steepen. These results show that U.S. inflation expectations and term premium have asymmetrical impacts on Korea’s yield curve.


During the current U.S. high inflation period, rising U.S. inflation expectations are forecast to act as significant upward pressure on Korea’s short- to medium-term interest rates through the monetary policy channel. This is because the U.S. has been maintaining its aggressive monetary tightening stance, including significant policy rate hikes and the implementation of quantitative tightening. In addition, upside risks to inflation are expanding and inflation expectations are rising in Korea as well, due to the global shock from rising commodity prices resulting from the prolonged Ukraine crisis, and due to the inflation expectations channel through which inflation expectations in Korea synchronize with those in the U.S. Considering these domestic and external conditions, there is an urgent need to manage inflation expectations in order to achieve the monetary policy goal of price stability. The Bank of Korea has been responding to inflation expectations more preemptively than other countries, by sending signals of normalizing monetary policy since May 2021 and by starting to raise the Base Rate in August last year. However, as inflationary pressures have been intensifying due to the Ukraine crisis, it is becoming even more difficult to manage market participant inflation expectations. Meanwhile, close monitoring is needed of the impact of the U.S. Federal Reserve's quantitative tightening, starting in June this year, on Korea’s market interest rates. Although this paper finds that the U.S. Federal Reserve's quantitative tightening did not have a significant effect on Korea’s term premium in the past, its impact is hard to predict this time given that the pace of current quantitative tightening is faster than that in the past and has been implemented together with rate hikes.

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