Disagreement in Inflation Forecasts and Inflation Risk Premia in Brazil

Abstract

The aim of this study is to investigate the link between the inflation risk premia implied by the term structures of nominal and real interest rates in Brazil and disagreements in inflation forecasts. We gauge the former by the difference between the breakeven inflation rate and agents' inflation median expectations in the Focus Survey published by the Central Bank of Brazil. To proxy for disagreement, we employ the standard deviation of the 12-month inflation expectations in the Focus Survey. We first estimate the impact of disagreement on inflation risk premia across different horizons using a VAR approach. We find that shocks in inflation forecast disagreement significantly affect the 9-, 12-, 24-and 36-month inflation risk premia. The impact is positive, increasing with maturity at least up to 12 months. We then estimate an alternative VAR specification that summarizes the term structure of inflation risk premia by means of level, slope and curvature factors. It turns out that shocks in disagreement do not affect the slope and curvature factors, resulting only in parallel shifts in the inflation premium term structure. This is in line with the fact that the higher the dispersion in inflation expectations, the higher is the compensation that investors will require to hold fixed rate bonds.

The natural yield curve in Brazil

“…In most cases considered in their model, higher disagreement leads to a higher inflation risk premium. Importantly for Brazil, Nunes, Doi & Fernandes (2017) find that a shock on inflation disagreeement, measured by the standard deviation of 12-month-ahead inflation expectations, leads to an increase in the level of the term structure of inflation risk premium, so there is evidence to use disagreement as a proxy for the inflation risk premium.…”