What Drives Long-Term Interest Rates? Evidence from the Entire Swiss Franc History 1852-2022

Abstract

We study the role of inflation uncertainty driving movements in real interest rates using newly compiled data for Switzerland and its main trading partners over 170 years. We use a time-varying parameter vector autoregressive model to estimate long-term trends in interest rates, exchange rate growth, and inflation. The model allows us to compute trends in the Swiss term spread and deviations from UIP and relate them to various measures of inflation uncertainty. We focus on these spreads because a good theory of long-term interest rate movements should not only explain the level, but also, differences across maturities and across countries. In addition, we provide a formal theoretical argument why a country focusing more on nominal stability than the rest of the world exhibits lower real interest rates. The Swiss term spread emerged after World War 1, the first time inflation became a persistent phenomenon since the introduction of the Swiss franc. In addition, negative deviations from UIP, that is relatively low Swiss real interest rates, emerged during the Great Inflation period. At the time, Switzerland managed to keep inflation lower than the rest of the world and capital controls largely disappeared. We find a positive relationship between the term spread and deviations from UIP with various measures of inflation uncertainty even after controlling for productivity growth and demographic change.