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Forecasting Inflation and the Inflation Risk Premiums Using Nominal Yields

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  • Bruno Feunou
  • Jean-Sébastien Fontaine

Abstract

We provide a decomposition of nominal yields into real yields, expectations of future inflation and inflation risk premiums when real bonds or inflation swaps are unavailable or unreliable due to their relative illiquidity. We combine nominal yields with surveys of inflation forecasts within a no-arbitrage model where conditional expectations are latent but spanned by the history of the observed data, analog to a GARCH model for the conditional variance. The filtering problem is numerically trivial and we conduct a battery of out-of-sample comparisons. Our favored model matches the quarterly inflation forecasts from surveys and uses the information in yields to produce the best monthly forecasts. Moreover, we restrict the distribution of the inflation Sharpe ratios to achieve economically reasonable estimates of the inflation risk premium and of the real rates. We find that the inflation risk premium (i) is positive on average, (ii) rises when the unemployment rate increases and (iii) when the level of interest rates decreases. Hence, real yields are more pro-cyclical than nominal yields due to variations of the inflation risk premiums.

Suggested Citation

  • Bruno Feunou & Jean-Sébastien Fontaine, 2012. "Forecasting Inflation and the Inflation Risk Premiums Using Nominal Yields," Staff Working Papers 12-37, Bank of Canada.
  • Handle: RePEc:bca:bocawp:12-37
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    References listed on IDEAS

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    Cited by:

    1. Bruno Feunou & Jean-Sébastien Fontaine, 2018. "Bond Risk Premia and Gaussian Term Structure Models," Management Science, INFORMS, vol. 64(3), pages 1413-1439, March.
    2. Michael Hatcher, 2013. "The inflation risk premium on government debt in an overlapping generations model," Working Papers 2013_17, Business School - Economics, University of Glasgow.

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    More about this item

    Keywords

    Asset Pricing; Econometric and statistical methods; Inflation and prices; Interest rates;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E47 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Forecasting and Simulation: Models and Applications
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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