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Liquidity risk premia and breakeven inflation rates

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  • Pu Shen

Abstract

In recent years, monetary policymakers have monitored several measures of market expectations of future inflation. One of these measures is based on the yield differential between nominal and inflation indexed Treasury securities. This yield spread is also called the ?breakeven inflation rate.? An increase in the breakeven rate is sometimes viewed as a sign that market inflation expectations may be on the rise. For example, the FOMC frequently refers to the yield spread as a measure of ?inflation compensation? and considers the yield spread an indicator of inflation expectations in policy deliberations. ; Accurately inferring market expectations of inflation from yield spreads is difficult. The difficulty lies in the differences in market liquidity conditions between nominal and inflation indexed Treasury securities. ; Shen presents evidence that liquidity differences between nominal and inflation indexed Treasuries have been nontrivial. Consequently, simply attributing changes in yield spreads to changes in market inflation expectations and ignoring the liquidity risk premium could lead to inaccurate inflation expectations.

Suggested Citation

  • Pu Shen, 2006. "Liquidity risk premia and breakeven inflation rates," Economic Review, Federal Reserve Bank of Kansas City, vol. 91(Q II), pages 29-54.
    • Handle: RePEc:fip:fedker:y:2006:i:qii:p:29-54:n:v.91no.2
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    Cited by:

    1. Equiza-Goñi, Juan & Faraglia, Elisa & Oikonomou, Rigas, 2023. "Union debt management," Journal of International Money and Finance, Elsevier, vol. 130(C).
    2. Auckenthaler, Julia & Kupfer, Alexander & Sendlhofer, Rupert, 2015. "The impact of liquidity on inflation-linked bonds: A hypothetical indexed bonds approach," The North American Journal of Economics and Finance, Elsevier, vol. 32(C), pages 139-154.
    3. Gilbert Cette & Marielle de Jong, 2013. "Breakeven inflation rates and their puzzling correlation relationships," Applied Economics, Taylor & Francis Journals, vol. 45(18), pages 2579-2585, June.
    4. Westerhout, Ed & Ciocyte, Ona, 2017. "The Role of Inflation-Linked Bonds. Increasing, but Still Modest," Discussion Paper 2017-027, Tilburg University, Center for Economic Research.
    5. Macchiarelli, Corrado, 2014. "Bond market co-movements, expected inflation and the GBP-USD equilibrium real exchange rate," The Quarterly Review of Economics and Finance, Elsevier, vol. 54(2), pages 242-256.
    6. Paul Söderlind, 2011. "Inflation Risk Premia and Survey Evidence on Macroeconomic Uncertainty," International Journal of Central Banking, International Journal of Central Banking, vol. 7(2), pages 113-133, June.
    7. Tamim Bayoumi & Andrew Swiston, 2010. "The Ties that Bind: Measuring International Bond Spillovers Using Inflation-Indexed Bond Yields," IMF Staff Papers, Palgrave Macmillan, vol. 57(2), pages 366-406, June.
    8. Montes, Gabriel Caldas & Curi, Alexandre, 2017. "Disagreement in expectations about public debt, monetary policy credibility and inflation risk premium," Journal of Economics and Business, Elsevier, vol. 93(C), pages 46-61.
    9. Westerhout, Ed & Ciocyte, Ona, 2017. "The Role of Inflation-Linked Bonds. Increasing, but Still Modest," Other publications TiSEM 08878bbd-e76e-4216-bee9-b, Tilburg University, School of Economics and Management.
    10. Zeng, Zheng, 2013. "New tips from TIPS: Identifying inflation expectations and the risk premia of break-even inflation," The Quarterly Review of Economics and Finance, Elsevier, vol. 53(2), pages 125-139.
    11. Ed Westerhout & Ona Ciocyte, 2017. "The role of inflation-linked bonds," CPB Discussion Paper 344.rdf, CPB Netherlands Bureau for Economic Policy Analysis.
    12. Duran, Murat & Gülşen, Eda, 2013. "Estimating inflation compensation for Turkey using yield curves," Economic Modelling, Elsevier, vol. 32(C), pages 592-601.

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    Keywords

    Inflation (Finance);

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