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

  • Kajuth, Florian
  • Watzka, Sebastian

Abstract We propose a novel method to correct break-even inflation rates derived from index-linked bonds for liquidity and inflation risk premia without resorting to survey based measures. In a state-space framework the difference between break-even inflation rates and unobserved true inflation expectation is explained by measures of time-varying liquidity and inflation risk premia. Our results have better forecasting performance for the average annual inflation rate over the following 10 years than raw break-even rates and the Survey of Professional Forecasters.

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Article provided by Elsevier in its journal The Quarterly Review of Economics and Finance.

Volume (Year): 51 (2011)
Issue (Month): 3 (June)
Pages: 225-235

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Handle: RePEc:eee:quaeco:v:51:y:2011:i:3:p:225-235
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  1. Stefania D'Amico & Don H Kim & Min Wei, 2008. "Tips from TIPS: the informational content of Treasury Inflation-Protected Security prices," BIS Working Papers 248, Bank for International Settlements.
  2. Refet S. Gürkaynak & Brian Sack & Jonathan H. Wright, 2010. "The TIPS Yield Curve and Inflation Compensation," American Economic Journal: Macroeconomics, American Economic Association, vol. 2(1), pages 70-92, January.
  3. Pierre-Olivier Weill & Dimitri Vayanos, 2007. "A Search-Based Theory of the On-the-Run Phenomenon," FMG Discussion Papers dp577, Financial Markets Group.
  4. 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.
  5. John Y. Campbell & Robert J. Shiller & Luis M. Viceira, 2009. "Understanding Inflation-Indexed Bond Markets," Cowles Foundation Discussion Papers 1696, Cowles Foundation for Research in Economics, Yale University.
  6. Hördahl, Peter & Tristani, Oreste, 2007. "Inflation risk premia in the term structure of interest rates," Working Paper Series 0734, European Central Bank.
  7. Joseph G. Haubrich & George Pennacchi & Peter H. 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.
  8. 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.
  9. Juan Angel Garcia & Adrian van Rixtel, 2007. "Inflation-linked bonds from a central bank perspective," Occasional Papers 0705, Banco de España;Occasional Papers Homepage.
  10. Stephen Leybourne & Tae-Hwan Kim & Vanessa Smith & Paul Newbold, 2003. "Tests for a change in persistence against the null of difference-stationarity," Econometrics Journal, Royal Economic Society, vol. 6(2), pages 291-311, December.
  11. Hördahl, Peter & Tristani, Oreste, 2010. "Inflation risk premia in the US and the euro area," Working Paper Series 1270, European Central Bank.
  12. Refet S. Gürkaynak & Brian P. 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.).
  13. García, Juan Angel & Werner, Thomas, 2010. "Inflation risks and inflation risk premia," Working Paper Series 1162, European Central Bank.
  14. Fama, Eugene F. & Gibbons, Michael R., 1982. "Inflation, real returns and capital investment," Journal of Monetary Economics, Elsevier, vol. 9(3), pages 297-323.
  15. Dean Croushore, 1993. "Introducing: the survey of professional forecasters," Business Review, Federal Reserve Bank of Philadelphia, issue Nov, pages 3-15.
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