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This paper develops a model of the term structures of nominal and real interest rates driven by state variables representing the short-term real interest rate, expected infl ation, infl ation's central tendency, and four volatility factors that follow GARCH processes. We derive analytical solutions for nominal bond yields, yields on infl ation-indexed bonds that have an indexation lag, and the term structure of expected infl ation. Unlike prior studies, the model's parameters are estimated using data on infl ation swap rates, as well as nominal yields and survey forecasts of infl ation. The volatility state variables fully determine bonds' timevarying risk premia and allow for stochastic volatility and correlation between bond yields, yet they have small effects on the cross section of nominal yields. Allowing for time-varying volatility is particularly important for real interest rate and expected infl ation processes, but long-horizon real and infl ation risk premia are relatively stable. Comparing our model prices of infl ation-indexed bonds to those of Treasury Infl ation Protected Securities (TIPS) suggests that TIPS were signifi cantly underpriced prior to 2004 and again during the 2008-2009 fi nancial crisis.

This paper brings historical evidence to bear on the stylized fact that the yield curve predicts future growth. The spread between corporate bonds and commercial paper reliably predicts future growth over the period 1875-1997. This predictability varies over time, however, particularly across different monetary regimes. In accord with our proposed theory, regimes with low credibility (high persistence of inflation) tend to have better predictability.