Real Rates, Expected Inflation, and Inflation Risk Premia

Abstract

This paper studies the term structure of real rates, expected inflation, and inflation risk premia. The analysis is based on new estimates of the real term structure derived from the prices of index-linked and nominal debt in the U.K. I find strong evidence to reject both the Fisher Hypothesis and versions of the Expectations Hypothesis for real rates. The estimates also imply the presence of time-varying inflation risk premia throughout the term structure. The Bank of England. I am grateful for the hospitality I received at both institutions and acknowledge the financial support of the Houblon-Norman Fund at the Bank of England.1 The theoretical arguments for issuing real debt go back to the 1700s according to Fisher (1913). Campbell and Shiller (1996) provide an overview of recent theoretical discussions concerning the relative merits of nominal and real debt.2 In 1994 there was £57 billion of U.K. IL debt outstanding, representing 15% of total marketable debt, with an average daily turnover of over £250 million. For further information on the comparative size of IL debt markets around the world, see Bank of England (1995).

Inflation Risk Premia in the US and the Euro Area

“…we assume that the in ‡ation risk borne by investors because of the indexation lag (the fact that there exists a lag between the publication of the in ‡ation index and the indexation of the bond) is negligible. Evans (1998) estimates the indexation-lag premium for UK index-linked bonds, and …nds that it is likely to be quite small, around 1.5 basis points.…”

Inflation Expectations, Real Rates, and Risk Premia: Evidence from Inflation Swaps

“…3 Similarly, Barr and Campbell (1997) and Evans (1998) use UK data on yields from nominal and indexed-linked gilts.…”

Break-Even Inflation Rate and the Risk Premium: An Alternative Approach to the VAR Models in Forecasting the CPI

“…Many studies investigated and supported the use of inflation-linked bonds to monitor inflation expectations. Among others, we can cite Hetzel (1992), Breedon (1995), Campbell and Shiller (1996), Deacon and Andrews (1996), Barr and Campbell (1997), Kitamura (1997), Evans (1998), Emmons (2000), Jarrow and Yildirim (2003), Bernanke (2004), Buraschi and Jiltsov (2005), Hordahl et al (2005), Liu and Cheng (2005), D'Amico et al (2006), Ang et al (2007), Garcia and van Rixtel (2007), Haubrich et al (2008) and Grishenko and Huang (2010).…”