A measure of the credibility of monetary policy is the inflation risk premium embodied in nominal yields. This will be time varying and can be estimated by combining the information contained in the nominal term structure of interest rates with that in the real term structure of inflation-indexed bonds. Information can also be obtained about the real risk premium, and about expected inflation. We estimate these risk premia using a generalization of the Cox-Ingersoll-Ross (CIR) affine-yield model. We use a one-factor model of the real term structure based on monthly observations on two-year, five-year and ten-year UK index-linked debt, and a two-factor model of the nominal term structure for the corresponding nominal yields. Our estimates show that the inflation risk premium contributes on average about 100 basis points to nominal yields. Since the exit from the Exchange Rate Mechanism (ERM) this has fallen to about 70 basis points. This shows the greater credibility of monetary policy in recent years. The real risk premium is much higher, and has fluctuated between 170 and 260 basis points since exit from the ERM, reflecting uncertainty about the real economy. The inflation risk premium provides a correction to the break-even method of forecasting inflation and produces an unbiased forecast.
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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number
2022.
Find related papers by JEL classification: E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Determination of Interest Rates; Term Structure of Interest Rates E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
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