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Inflation expectations from index-linked bonds: Correcting for liquidity and inflation risk premia

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  • Kajuth, Florian
  • Watzka, Sebastian

Abstract

Abstract We propose a novel method to correct break-even inflation rates derived from index-linked bonds for liquidity and inflation risk premia without resorting to survey based measures. In a state-space framework the difference between break-even inflation rates and unobserved true inflation expectation is explained by measures of time-varying liquidity and inflation risk premia. Our results have better forecasting performance for the average annual inflation rate over the following 10 years than raw break-even rates and the Survey of Professional Forecasters.

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Bibliographic Info

Article provided by Elsevier in its journal The Quarterly Review of Economics and Finance.

Volume (Year): 51 (2011)
Issue (Month): 3 (June)
Pages: 225-235

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Handle: RePEc:eee:quaeco:v:51:y:2011:i:3:p:225-235

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Web page: http://www.elsevier.com/locate/inca/620167

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Keywords: Inflation expectations Liquidity risk premium Inflation risk premium Treasury inflation-protected securities (TIPS) State-space model;

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References

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  1. Kajuth, Florian & Watzka, Sebastian, 2008. "Inflation expectations from index-linked bonds: Correcting for liquidity and inflation risk premia," Discussion Papers in Economics 4858, University of Munich, Department of Economics.
  2. Stefania D'Amico & Don H Kim & Min Wei, 2008. "Tips from TIPS: the informational content of Treasury Inflation-Protected Security prices," BIS Working Papers 248, Bank for International Settlements.
  3. Stephen Leybourne & Tae-Hwan Kim & Vanessa Smith & Paul Newbold, 2003. "Tests for a change in persistence against the null of difference-stationarity," Econometrics Journal, Royal Economic Society, vol. 6(2), pages 291-311, December.
  4. John Y. Campbell & Robert J. Shiller & Luis M. Viceira, 2009. "Understanding Inflation-Indexed Bond Markets," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 40(1 (Spring), pages 79-138.
  5. Peter Hoerdahl & Oreste Tristani, 2007. "Inflation risk premia in the term structure of interest rates," BIS Working Papers 228, Bank for International Settlements.
  6. Fama, Eugene F. & Gibbons, Michael R., 1982. "Inflation, real returns and capital investment," Journal of Monetary Economics, Elsevier, vol. 9(3), pages 297-323.
  7. Paul Söderlind, 2008. "Inflation Risk Premia and Survey Evidence on Macroeconomic Uncertainty," University of St. Gallen Department of Economics working paper series 2008 2008-12, Department of Economics, University of St. Gallen.
  8. Hördahl, Peter & Tristani, Oreste, 2010. "Inflation risk premia in the US and the euro area," Working Paper Series 1270, European Central Bank.
  9. Juan Angel Garcia & Adrian van Rixtel, 2007. "Inflation-linked bonds from a Central Bank perspective," Occasional Paper Series 62, European Central Bank.
  10. Dean Croushore, 1993. "Introducing: the survey of professional forecasters," Business Review, Federal Reserve Bank of Philadelphia, issue Nov, pages 3-15.
  11. Joseph G. Haubrich & George Pennacchi & Peter Ritchken, 2008. "Estimating real and nominal term structures using Treasury yields, inflation, inflation forecasts, and inflation swap rates," Working Paper 0810, Federal Reserve Bank of Cleveland.
  12. Pierre-Olivier Weill & Dimitri Vayanos, 2005. "A Search-Based Theory of the On-the-Run Phenomenon," 2005 Meeting Papers 701, Society for Economic Dynamics.
  13. Shiller, Robert J. & Campbell, John Y. & Viceira, Luis Manuel, 2009. "Understanding Inflation-Indexed Bond Markets," Scholarly Articles 10885503, Harvard University Department of Economics.
  14. Refet S. Gürkaynak & Brian Sack & Jonathan H. Wright, 2006. "The U.S. Treasury yield curve: 1961 to the present," Finance and Economics Discussion Series 2006-28, Board of Governors of the Federal Reserve System (U.S.).
  15. Refet S. Gürkaynak & Brian Sack & Jonathan H. Wright, 2008. "The TIPS yield curve and inflation compensation," Finance and Economics Discussion Series 2008-05, Board of Governors of the Federal Reserve System (U.S.).
  16. García, Juan Angel & Werner, Thomas, 2010. "Inflation risks and inflation risk premia," Working Paper Series 1162, European Central Bank.
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Cited by:
  1. Paul Söderlind, 2008. "Inflation Risk Premia and Survey Evidence on Macroeconomic Uncertainty," University of St. Gallen Department of Economics working paper series 2008 2008-12, Department of Economics, University of St. Gallen.
  2. Kajuth, Florian & Watzka, Sebastian, 2008. "Inflation expectations from index-linked bonds: Correcting for liquidity and inflation risk premia," Discussion Papers in Economics 4858, University of Munich, Department of Economics.

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