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Real Return Bonds, Inflation Expectations, and the Break-Even Inflation Rate

  • Christensen, Ian
  • Frédéric Dion
  • Christopher Reid

According to the Fisher hypothesis, the gap between Canadian nominal and Real Return Bond yields (or break-even inflation rate) should be a good measure of inflation expectations. The authors find that this measure was higher, on average, and more variable than survey measures of inflation expectations between 1992 and 2003. They examine whether risk premiums and distortions embedded in this interest rate gap can account for these facts. Their results indicate that distortions were likely an important reason for the high level and variation of this measure over much of the 1990s. There is little evidence that the distortions examined were as important between 2000 and 2003, but the high level of the break-even inflation rate in 2004 may be evidence of their return. Given the potential distortions, and the difficulty in identifying them, the authors conclude that it is premature to consider this measure a reliable gauge of monetary policy credibility. In addition, it is not as useful as competing tools for short- and medium-term inflation forecasting.

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Paper provided by Bank of Canada in its series Working Papers with number 04-43.

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Length: 47 pages
Date of creation: 2004
Date of revision:
Handle: RePEc:bca:bocawp:04-43
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  1. Francis Breedon & Jag Chadha, 1997. "The Information Content of the Inflation Term Structure," Bank of England working papers 75, Bank of England.
  2. Pu Shen & Jonathan Corning, 2001. "Can TIPS help identify long-term inflation expectations?," Economic Review, Federal Reserve Bank of Kansas City, issue Q IV, pages 61-87.
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  7. Brian Sack & Robert Elsasser, 2004. "Treasury inflation-indexed debt: a review of the U.S. experience," Economic Policy Review, Federal Reserve Bank of New York, issue May, pages 47-63.
  8. Mayer, T., 1993. "Indexed Bonds and Heterogenous Agents," Papers 93-07, California Davis - Institute of Governmental Affairs.
  9. Crawford, A & Kasumovich, M, 1996. "Does Inflation Uncertainty Vary with the Level of Inflation?," Working Papers 96-09, Bank of Canada.
  10. Frédérick Demers, 2003. "The Canadian Phillips Curve and Regime Shifting," Working Papers 03-32, Bank of Canada.
  11. Barr, David & Campbell, John, 1997. "Inflation, Real Interest Rates, and the Bond Market: A Study of UK Nominal and Index-Linked Government Bond Prices," Scholarly Articles 3163261, Harvard University Department of Economics.
  12. Brian Sack, 2000. "Deriving inflation expectations from nominal and inflation-indexed Treasury yields," Finance and Economics Discussion Series 2000-33, Board of Governors of the Federal Reserve System (U.S.).
  13. Refet S. Gürkaynak & Brian Sack & Eric Swanson, 2003. "The excess sensitivity of long-term interest rates: evidence and implications for macroeconomic models," Finance and Economics Discussion Series 2003-50, Board of Governors of the Federal Reserve System (U.S.).
  14. Martin D. D. Evans, 1998. "Real Rates, Expected Inflation, and Inflation Risk Premia," Journal of Finance, American Finance Association, vol. 53(1), pages 187-218, 02.
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  16. David Jamieson Bolder & Scott Gusba, 2002. "Exponentials, Polynomials, and Fourier Series: More Yield Curve Modelling at the Bank of Canada," Working Papers 02-29, Bank of Canada.
  17. Christopher Reid & Frédéric Dion & Ian Christensen, 2004. "Real Return Bonds: Monetary Policy Credibility and Short-Term Inflation Forecasting," Bank of Canada Review, Bank of Canada, vol. 2004(Autumn), pages 15-26.
  18. William R. Emmons, 2000. "The information content of Treasury inflation-indexed securities," Review, Federal Reserve Bank of St. Louis, issue Nov, pages 25-38.
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