An infinite hidden Markov model for short-term interest rates *

•Extend short-rate models to Markov switching of infinite dimension•A Bayesian nonparametric model•Significant improvements in density forecasts•Flexible approach captures changes in the conditional distribution.•Evidence of recurring regimes as well as structural breaks

The time-series dynamics of short-term interest rates are important as they are a key input into pricing models of the term structure of interest rates. In this paper we extend popular discrete time short-rate models to include Markov switching of infinite dimension. This is a Bayesian nonparametric model that allows for changes in the unknown conditional distribution over time. Applied to weekly U.S. data we find significant parameter change over time and strong evidence of non-Gaussian conditional distributions. Our new model with a hierarchical prior provides significant improvements in density forecasts as well as point forecasts. We find evidence of recurring regimes as well as structural breaks in the empirical application.