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Inflation risk in the U.S. yield curve: the usefulness of indexed bonds

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  • Frank F. Gong
  • Eli M. Remolona
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    Abstract

    The inflation-indexed bonds the U.S. Treasury plans to issue will reduce the expected borrowing cost if the yield curve reflects a risk premium for inflation. In the United Kingdom, indexed bonds are also used to extract inflationary expectations and thus to guide monetary policy. The bonds will produce a more reliable measure of such expectations if the inflation risk premium is taken into account. We estimate such a risk premium for the United States by means of a two-factor affine-yield model of the term structure. The model allows both the inflation risk premium and real term premium to vary over time. Using monthly data on CPI inflation and on bond yields for two-year to ten-year maturities, we find both premia to have been significant for the sample period January 1984 to July 1996. We estimate that indexed bonds would have saved an average of one-fifth of the expected borrowing cost of 10-year notes.

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    Bibliographic Info

    Paper provided by Federal Reserve Bank of New York in its series Research Paper with number 9637.

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    Date of creation: 1996
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    Handle: RePEc:fip:fednrp:9637

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    Keywords: Inflation-indexed bonds ; Bonds ; Inflation (Finance) ; Indexation (Economics) ; Interest rates;

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    Cited by:
    1. LuisM. Viceira & John Y. Campbell, 2001. "Who Should Buy Long-Term Bonds?," American Economic Review, American Economic Association, vol. 91(1), pages 99-127, March.
    2. Reschreiter, Andreas, 2008. "Lower borrowing costs with inflation-indexed bonds: A trading rule based assessment," Economics Letters, Elsevier, vol. 99(2), pages 272-274, May.
    3. Kanas, Angelos, 2014. "Bond futures, inflation-indexed bonds, and inflation risk premium," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 28(C), pages 82-99.
    4. Madureira, Leonardo, 2007. "The ex ante real rate and inflation premium under a habit consumption model," Journal of Empirical Finance, Elsevier, vol. 14(3), pages 355-382, June.
    5. Reschreiter, Andreas, 2004. "Conditional funding costs of inflation-indexed and conventional government bonds," Journal of Banking & Finance, Elsevier, vol. 28(6), pages 1299-1318, June.

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