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What was the market's view of U.K. monetary policy? Estimating inflation risk and expected inflation with indexed bonds

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Author Info
Eli M. Remolona
Michael R. Wickens
Frank F. Gong

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Abstract

A measure of the credibility of monetary policy is the inflation risk premium in nominal yields. This will be time varying and can be estimated by combining the information in the nominal term structure with that in the real term structure. We estimate these risk premia using a generalized CIR affine-yield model, with one factor driving the real term structure of monthly observations on two-year, five-year and ten-year UK index-linked debt and two factors driving the term structure of 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 ERM this has fallen to 70 basis points, showing greater policy credibility. 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 Federal Reserve Bank of New York in its series Staff Reports with number 57.

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Date of creation: 1998
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Handle: RePEc:fip:fednsr:57

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Related research
Keywords: Inflation (Finance) - Great Britain ; Forecasting ; Risk ; Monetary policy - Great Britain ; Great Britain;

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  1. Jorge Barros Luís & Nuno Cassola, 2001. "A two-factor model of the German term structure of interest rates," Working Paper Series 46, European Central Bank. [Downloadable!]
  2. Mike R Wickens & Peter N Smith, . "Macroeconmic Sources of FOREX Risk," Discussion Papers 01/13, Department of Economics, University of York. [Downloadable!]
    Other versions:
  3. Andrew Ang & Geert Bekaert, 2004. "The term structure of real rates and expected inflation," Proceedings, Federal Reserve Bank of San Francisco, issue Mar. [Downloadable!]
    Other versions:
  4. Peter Hördahl, 2008. "The inflation risk premium in the term structure of interest rates," BIS Quarterly Review, Bank for International Settlements, September. [Downloadable!]
  5. Fung, Ben & Mitnick, Scott & Remolona, Eli, 1999. "Uncovering Inflation Expectations and Risk Premiums From Internationally Integrated Financial Markets," Working Papers 99-6, Bank of Canada. [Downloadable!]
  6. Martin Evans, 1998. "Looking Behind the U. K.Term Structure: Were there Peso Problems in Inflation?," Finance 9809001, EconWPA. [Downloadable!]
  7. Peter N Smith & Michael R Wickens, . "Asset Pricing with Observable Stochastic Discount Factors," Discussion Papers 02/03, Department of Economics, University of York. [Downloadable!]
    Other versions:
  8. Juan Angel Garcia & Adrian van Rixtel, 2007. "Inflation-linked bonds from a central bank perspective," Banco de España Occasional Papers 0705, Banco de España. [Downloadable!]
    Other versions:
  9. Peter Hördahl & Oreste Tristani, 2007. "Mortage interest rate dispersion in the euro area," Working Paper Series 734, European Central Bank. [Downloadable!]
  10. Nuno Cassola & Jorge Barros Luís, 2003. "A two-factor model of the German term structure of interest rates," Applied Financial Economics, Taylor and Francis Journals, vol. 13(11), pages 783-806, November. [Downloadable!] (restricted)
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