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Inflation, Real Interest Rates, and the Bond Market: A Study of UK Nominal and Index-Linked Government Bond Prices

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  • David G. Barr
  • John Y. Campbell

Abstract

This paper estimates expected future real interest rates and inflation rates from observed prices of UK government nominal and index-linked bonds. The estimation method takes account of imperfections in the indexation of UK index-linked bonds. It assumes that expected log returns on all bonds are equal, and that expected real interest rates and inflation follow simple time-series processes whose parameters can be estimated from the cross-section of bond prices. The extracted inflation expectations forecast actual future inflation more accurately than nominal yields do. The estimated real interest rate is highly variable at short horizons, but comparatively stable at long horizons. Changes in real rates and expected inflation are strongly negatively correlated at short horizons, but not at long horizons.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 5821.

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Date of creation: Nov 1996
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Publication status: published as Journal of Monetary Economics, Vol. 39 (August 1997): 361-383.
Handle: RePEc:nbr:nberwo:5821

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  1. John Y. Campbell & Robert J. Shiller, 1996. "A Scorecard for Indexed Government Debt," NBER Working Papers 5587, National Bureau of Economic Research, Inc.
  2. Ammer, John & Campbell, John, 1993. "What Moves the Stock and Bond Markets? A Variance Decomposition for Long-Term Asset Returns," Scholarly Articles 3382857, Harvard University Department of Economics.
  3. 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.
  4. Mark Deacon & Andrew Derry, 1994. "Estimating the Term Structure of Interest Rates," Bank of England working papers 24, Bank of England.
  5. John Y. Campbell & Robert J. Shiller, 1989. "Yield Spreads and Interest Rate Movements: A Bird's Eye View," NBER Working Papers 3153, National Bureau of Economic Research, Inc.
  6. Mishkin, Frederic S., 1990. "What does the term structure tell us about future inflation?," Journal of Monetary Economics, Elsevier, vol. 25(1), pages 77-95, January.
  7. John Y. Campbell, 1995. "Some Lessons from the Yield Curve," Journal of Economic Perspectives, American Economic Association, vol. 9(3), pages 129-152, Summer.
  8. Robert J. Shiller & John Y. Campbell & Kermit L. Schoenholtz, 1983. "Forward Rates and Future Policy: Interpreting the Term Structure of Interest Rates," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 14(1), pages 173-224.
  9. Sun, Tong-sheng, 1992. "Real and Nominal Interest Rates: A Discrete-Time Model and Its Continuous-Time Limit," Review of Financial Studies, Society for Financial Studies, vol. 5(4), pages 581-611.
  10. White, Halbert, 1980. "A Heteroskedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Heteroskedasticity," Econometrica, Econometric Society, vol. 48(4), pages 817-38, May.
  11. John Y. Campbell & Robert J. Shiller, 1996. "A Scorecard for Indexed Government Data," Harvard Institute of Economic Research Working Papers 1758, Harvard - Institute of Economic Research.
  12. Hansen, Lars Peter & Hodrick, Robert J, 1980. "Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis," Journal of Political Economy, University of Chicago Press, vol. 88(5), pages 829-53, October.
  13. Fama, Eugene F & Bliss, Robert R, 1987. "The Information in Long-Maturity Forward Rates," American Economic Review, American Economic Association, vol. 77(4), pages 680-92, September.
  14. Mark Deacon & Andrew Derry, 1994. "Deriving Estimates of Inflation Expectations from the Prices of UK Government Bonds," Bank of England working papers 23, Bank of England.
  15. Hahn, Frank, 1990. "On Inflation," Oxford Review of Economic Policy, Oxford University Press, vol. 6(4), pages 15-25, Winter.
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