Extracting inflation expectations and inflation risk premia from the term structure: a joint model of the UK nominal and real yield curves
AbstractThis paper analyses the nominal and real interest rate term structures in the United Kingdom over the fifteen-year period that the UK monetary authorities have pursued an explicit inflation target, using a four-factor essentially affine term structure model. The model imposes no-arbitrage restrictions across nominal and real yields, enabling us to decompose nominal forward rates into expected real short rates, expected inflation, real term premia and inflation risk premia. We find that inflation risk premia and longer-term inflation expectations fell significantly when the Bank of England was made operationally independent in 1997. The 'conundrum' of unusually low long-term real rates that began in 2004 is mainly attributed by the model to a fall in real term premia, though a significant part of the fall is left unexplained. The relative inability of the model to fit long real forwards during much of this recent period may reflect strong pension fund demand for index-linked bonds. Moreover, the model decompositions suggest that these special factors affecting the index-linked market may also partly account for the contemporaneous rise in longer-horizon inflation breakeven rates.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by Bank of England in its series Bank of England working papers with number 360.
Length: 47 pages
Date of creation: 16 Feb 2009
Date of revision:
Contact details of provider:
Postal: Publications Group Bank of England Threadneedle Street London EC2R 8AH
Phone: +44 (0)171 601 4030
Fax: +44 (0)171 601 5196
Web page: http://www.bankofengland.co.uk/
More information through EDIRC
Inflation expectations; inflation risk premia; affine term structure model;
Other versions of this item:
- Joyce, Michael A.S. & Lildholdt, Peter & Sorensen, Steffen, 2010. "Extracting inflation expectations and inflation risk premia from the term structure: A joint model of the UK nominal and real yield curves," Journal of Banking & Finance, Elsevier, vol. 34(2), pages 281-294, February.
- C40 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - General
- E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
- E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
This paper has been announced in the following NEP Reports:
- NEP-ALL-2009-02-28 (All new papers)
- NEP-CBA-2009-02-28 (Central Banking)
- NEP-MAC-2009-02-28 (Macroeconomics)
- NEP-MON-2009-02-28 (Monetary Economics)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Don H. Kim & Jonathan H. Wright, 2005. "An arbitrage-free three-factor term structure model and the recent behavior of long-term yields and distant-horizon forward rates," Finance and Economics Discussion Series 2005-33, Board of Governors of the Federal Reserve System (U.S.).
- Darrell Duffie & Rui Kan, 1996. "A Yield-Factor Model Of Interest Rates," Mathematical Finance, Wiley Blackwell, vol. 6(4), pages 379-406.
- Brian Sack & Robert Elsasser, 2004. "Treasury inflation-indexed debt: a review of the U.S. experience," Economic Policy Review, Federal Reserve Bank of New York, issue May, pages 47-63.
- Martin D. D. Evans, 2003.
"Real risk, inflation risk, and the term structure,"
Royal Economic Society, vol. 113(487), pages 345-389, 04.
- Jacobs, Mike & Remolona, Eli & Wickens, Michael R, 1998.
"What was the Market's View of UK Monetary Policy? Estimating Inflation Risk and Expected Inflation with Indexed Bonds,"
CEPR Discussion Papers
2022, C.E.P.R. Discussion Papers.
- Eli M. Remolona & Michael R. Wickens & Frank F. Gong, 1998. "What was the market's view of U.K. monetary policy? Estimating inflation risk and expected inflation with indexed bonds," Staff Reports 57, Federal Reserve Bank of New York.
- Kozicki, Sharon & Tinsley, P. A., 2001.
"Shifting endpoints in the term structure of interest rates,"
Journal of Monetary Economics,
Elsevier, vol. 47(3), pages 613-652, June.
- Sharon Kozicki & P.A. Tinsley, 1997. "Shifting endpoints in the term structure of interest rates," Research Working Paper 97-08, Federal Reserve Bank of Kansas City.
- Gregory R. Duffee, 2002. "Term Premia and Interest Rate Forecasts in Affine Models," Journal of Finance, American Finance Association, vol. 57(1), pages 405-443, 02.
- Kanas, Angelos, 2008. "On real interest rate dynamics and regime switching," Journal of Banking & Finance, Elsevier, vol. 32(10), pages 2089-2098, October.
- Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, vol. 53(2), pages 385-407, March.
- Almeida, Caio & Vicente, José, 2008.
"The role of no-arbitrage on forecasting: Lessons from a parametric term structure model,"
Journal of Banking & Finance,
Elsevier, vol. 32(12), pages 2695-2705, December.
- Almeida, Caio Ibsen Rodrigues de & Vicente, José Valentim M., 2007. "The Role of No-Arbitrage on Forecasting: Lessons from a Parametric Term Structure Model," Economics Working Papers (Ensaios Economicos da EPGE) 657, FGV/EPGE Escola Brasileira de Economia e Finanças, Getulio Vargas Foundation (Brazil).
- Peter Lildholdt & Nikolaos Panigirtzoglou & Chris Peacock, 2007. "An affine macro-factor model of the UK yield curve," Bank of England working papers 322, Bank of England.
- Wright, Jonathan H. & Zhou, Hao, 2009. "Bond risk premia and realized jump risk," Journal of Banking & Finance, Elsevier, vol. 33(12), pages 2333-2345, December.
- Hiona Balfoussia & Mike Wickens, 2007.
"Macroeconomic Sources of Risk in the Term Structure,"
Journal of Money, Credit and Banking,
Blackwell Publishing, vol. 39(1), pages 205-236, 02.
- Chiona Balfoussia & Michael Wickens, 2004. "Macroeconomic Sources of Risk in the Term Structure," CESifo Working Paper Series 1329, CESifo Group Munich.
- Michael R. Wickens & Chiona Balfoussia, 2004. "Macroeconomic Sources of Risk in the Term Structure," CEIS Research Paper 61, Tor Vergata University, CEIS.
- Nicola Anderson & John Sleath, 2001. "New estimates of the UK real and nominal yield curves," Bank of England working papers 126, Bank of England.
- Joyce, Michael & Kaminska, Iryna & Lildholdt, Peter, 2008. "Understanding the real rate conundrum: an application of no-arbitrage finance models to the UK real yield curve," Bank of England working papers 358, Bank of England.
- Kim, Don H. & Orphanides, Athanasios, 2012.
"Term Structure Estimation with Survey Data on Interest Rate Forecasts,"
Journal of Financial and Quantitative Analysis,
Cambridge University Press, vol. 47(01), pages 241-272, February.
- Don H. Kim & Athanasios Orphanides, 2005. "Term structure estimation with survey data on interest rate forecasts," Finance and Economics Discussion Series 2005-48, Board of Governors of the Federal Reserve System (U.S.).
- Kim, Don H. & Orphanides, Athanasios, 2005. "Term Structure Estimation with Survey Data on Interest Rate Forecasts," CEPR Discussion Papers 5341, C.E.P.R. Discussion Papers.
- Athanasios Orphanides & Don H. Kim, 2005. "Term Structure Estimation with Survey Data on Interest Rate Forecasts," Computing in Economics and Finance 2005 474, Society for Computational Economics.
- Martin D. D. Evans, 1998. "Real Rates, Expected Inflation, and Inflation Risk Premia," Journal of Finance, American Finance Association, vol. 53(1), pages 187-218, 02.
- Andrew Ang & Monika Piazzesi, 2001.
"A No-Arbitrage Vector Autoregression of Term Structure Dynamics with Macroeconomic and Latent Variables,"
NBER Working Papers
8363, National Bureau of Economic Research, Inc.
- Ang, Andrew & Piazzesi, Monika, 2003. "A no-arbitrage vector autoregression of term structure dynamics with macroeconomic and latent variables," Journal of Monetary Economics, Elsevier, vol. 50(4), pages 745-787, May.
This item has more than 25 citations. To prevent cluttering this page, these citations are listed on a separate page. reading list or among the top items on IDEAS.Access and download statisticsgeneral information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Publications Team).
If references are entirely missing, you can add them using this form.