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Inflation expectations from index-linked bonds: Correcting for liquidity and inflation risk premia

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  • Kajuth, Florian
  • Watzka, Sebastian

Abstract

We provide a critical assessment of the method used by the Cleveland Fed to correct expected inflation derived from index-linked bonds for liquidity and inflation risk premia and show how their method can be adapted to account for time-varying inflation risk premia. Furthermore, we show how sensitive the Cleveland Fed approach is to different measures of the liquidity premium. In addition we propose an alternative approach to decompose the bias in inflation expectations derived from index-linked bonds using a state-space estimation. Our results show that once one accounts for time-varying liquidity and inflation risk premia current 10-year U.S. inflation expectations are lower than estimated by the Cleveland Fed.

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Bibliographic Info

Paper provided by University of Munich, Department of Economics in its series Discussion Papers in Economics with number 4858.

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Date of creation: 10 Jul 2008
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Handle: RePEc:lmu:muenec:4858

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Keywords: Inflation expectations; liquidity risk premium; inflation risk premium; treasury inflation-protected securities (TIPS); state-space model;

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  1. Hördahl, Peter & Tristani, Oreste, 2007. "Inflation risk premia in the term structure of interest rates," Working Paper Series 0734, European Central Bank.
  2. Shiller, Robert J. & Campbell, John Y. & Viceira, Luis Manuel, 2009. "Understanding Inflation-Indexed Bond Markets," Scholarly Articles 10885503, Harvard University Department of Economics.
  3. Hördahl, Peter & Tristani, Oreste, 2010. "Inflation risk premia in the US and the euro area," Working Paper Series 1270, European Central Bank.
  4. Stefania D'Amico & Don H. Kim & Min Wei, 2010. "Tips from TIPS: the informational content of Treasury Inflation-Protected Security prices," Finance and Economics Discussion Series 2010-19, Board of Governors of the Federal Reserve System (U.S.).
  5. Kajuth, Florian & Watzka, Sebastian, 2011. "Inflation expectations from index-linked bonds: Correcting for liquidity and inflation risk premia," The Quarterly Review of Economics and Finance, Elsevier, vol. 51(3), pages 225-235, June.
  6. Dean Croushore, 1993. "Introducing: the survey of professional forecasters," Business Review, Federal Reserve Bank of Philadelphia, issue Nov, pages 3-15.
  7. Refet S. Gürkaynak & Brian Sack & Jonathan H. Wright, 2006. "The U.S. Treasury yield curve: 1961 to the present," Finance and Economics Discussion Series 2006-28, Board of Governors of the Federal Reserve System (U.S.).
  8. García, Juan Angel & Werner, Thomas, 2010. "Inflation risks and inflation risk premia," Working Paper Series 1162, European Central Bank.
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  11. Paul Söderlind, 2008. "Inflation Risk Premia and Survey Evidence on Macroeconomic Uncertainty," University of St. Gallen Department of Economics working paper series 2008 2008-12, Department of Economics, University of St. Gallen.
  12. John Campbell & Robert Shiller & Luis Viceira, 2009. "Understanding Inflation-Indexed Bond Markets," Yale School of Management Working Papers amz2587, Yale School of Management.
  13. Fama, Eugene F. & Gibbons, Michael R., 1982. "Inflation, real returns and capital investment," Journal of Monetary Economics, Elsevier, vol. 9(3), pages 297-323.
  14. Joseph G. Haubrich & George Pennacchi & Peter Ritchken, 2008. "Estimating real and nominal term structures using Treasury yields, inflation, inflation forecasts, and inflation swap rates," Working Paper 0810, Federal Reserve Bank of Cleveland.
  15. Juan Angel Garcia & Adrian van Rixtel, 2007. "Inflation-linked bonds from a central bank perspective," Banco de Espa�a Occasional Papers 0705, Banco de Espa�a.
  16. Refet S. Gürkaynak & Brian Sack & Jonathan H. Wright, 2008. "The TIPS yield curve and inflation compensation," Finance and Economics Discussion Series 2008-05, Board of Governors of the Federal Reserve System (U.S.).
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Cited by:
  1. Paul Söderlind, 2008. "Inflation Risk Premia and Survey Evidence on Macroeconomic Uncertainty," University of St. Gallen Department of Economics working paper series 2008 2008-12, Department of Economics, University of St. Gallen.
  2. Kajuth, Florian & Watzka, Sebastian, 2008. "Inflation expectations from index-linked bonds: Correcting for liquidity and inflation risk premia," Discussion Papers in Economics 4858, University of Munich, Department of Economics.

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