Estimating the market premium in short term interest rates

Abstract

Looking at the term structure in the interest rate market one can’t help notice the evident market premium above the central banks target rate. What factors might decide this premium? By using different variations of simple regression models we see that the model is constantly lagging the real time series. Acknowledging the fact that market clearings often are subject to several equations; we’re better able to develop a sensible model using a simultaneous equilibrium model. The multiple equation model provides us with information about the importance of international factors as well as domestic economic variables, such as real assets and stock prices. We also find significant evidence for the simple Taylor rule using inflation deviation and GDP trend analysis. It’s also worth noting that exchange rates played a less important role in deciding the market premium after Norway introduced an inflation target in its monetary policy.