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The informational content of market-based measures of inflation expectations derived from govenment bonds and inflation swaps in the United Kingdom

Author

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  • Liu, Zhuoshi

    (China Investment Corporation)

  • Vangelista, Elisabetta

    (UK Debt Management Office)

  • Kaminska, Iryna

    (Bank of England)

  • Relleen, Jon

    (Bank of England)

Abstract

Market-based measures of inflation expectations can be derived either from the difference between yields on nominal and inflation-linked government bonds or from inflation swap rates. These measures are important indicators of the outlook for inflation and are monitored regularly by the United Kingdom’s Monetary Policy Committee (MPC), alongside other measures of inflation expectations such as those based on surveys. However, the market rates we observe are not perfect measures of expected future inflation. Moreover, in the United Kingdom inflation-linked market instruments reference RPI inflation, whereas the MPC’s target is CPI inflation of 2%. To better extract useful information about expectations for CPI inflation, we develop a no-arbitrage term structure model to decompose the forward inflation curve into: measures of CPI inflation expectations; the expected spread between expected RPI and CPI inflation (the RPI/CPI inflation ‘wedge’); and estimates of risk premia. We then further decompose risk premia estimates into inflation risk premia and liquidity risk premia. We show that long-horizon expectations of CPI inflation, as implied by our model, fell in the 1990s after the introduction of inflation targeting and the creation of the MPC and have since remained fairly stable at around 2%. Our model also suggests that the large falls in measures of implied inflation based on index-linked gilts after the financial crisis were to a large extent the result of changes in liquidity premia in inflation-linked gilt prices.

Suggested Citation

  • Liu, Zhuoshi & Vangelista, Elisabetta & Kaminska, Iryna & Relleen, Jon, 2015. "The informational content of market-based measures of inflation expectations derived from govenment bonds and inflation swaps in the United Kingdom," Bank of England working papers 551, Bank of England.
    • Handle: RePEc:boe:boeewp:0551
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    References listed on IDEAS

    as
    1. Michael D. Bauer, 2015. "Inflation Expectations and the News," International Journal of Central Banking, International Journal of Central Banking, vol. 11(2), pages 1-40, March.
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    3. Matthias Fleckenstein & Francis A. Longstaff & Hanno Lustig, 2014. "The TIPS-Treasury Bond Puzzle," Journal of Finance, American Finance Association, vol. 69(5), pages 2151-2197, October.
    4. Ernst R. Berndt & Bronwyn H. Hall & Robert E. Hall & Jerry A. Hausman, 1974. "Estimation and Inference in Nonlinear Structural Models," NBER Chapters, in: Annals of Economic and Social Measurement, Volume 3, number 4, pages 653-665, National Bureau of Economic Research, Inc.
    5. Kim, Jaehoon & Kim, Sangsin, 2015. "2012년 국회법 개정의 효과 연구 [A Study on the Effect of the 2012 National Assembly Act Amendment]," KDI Research Monographs, Korea Development Institute (KDI), volume 127, number v:2015-03(k):y:2015:p:1-1.
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    Cited by:

    1. Camba-Méndez, Gonzalo & Werner, Thomas, 2017. "The inflation risk premium in the post-Lehman period," Working Paper Series 2033, European Central Bank.
    2. Thórarinn G. Pétursson, 2022. "Long‐term inflation expectations and inflation dynamics," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 27(1), pages 158-174, January.
    3. Dooruj Rambaccussing & Craig Menzies & Andrzej Kwiatkowski, 2022. "Look who’s Talking: Individual Committee members’ impact on inflation expectations," Dundee Discussion Papers in Economics 305, Economic Studies, University of Dundee.

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    More about this item

    Keywords

    Affine arbitrage-free dynamic term structure model; breakeven inflation; inflation expectations; risk premia; funding liquidity; survey expectations;
    All these keywords.

    JEL classification:

    • C40 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - General
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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