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An assessment of the relative importance of real interest rates, inflation and term premia in determining the prices of real and nominal UK bonds

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  • David Barr
  • Bahram Pesaran

Abstract

This paper uses a dynamic accounting identity developed by Campbell to decompose movements in bond prices into elements due to changes in real interest rates, expected term premia and expected inflation. This decomposition is applied to UK short and long-maturity nominal bonds and index-linked bonds using data between 1983 and 1993. The main findings are that changes in expected inflation are by far the most important determinant of bond price movements. So much so that even for index-linked bonds changes in expected inflation (which have an effect due to the eight month indexation lag) are a more important factor than changes in real interest rates (which contribute less than 3% to the variance of index-linked bond prices). The paper also finds that changes in expected term premia are an important determinant of changes in both nominal and index-linked bond prices. However, the term premia appears to be a common factor which has little influence on the relative price of the two types of bond (ie break-even inflation rates). This suggests that changes in the relative price of the two type of bonds offer a reliable measure of changes in market expectations of inflation with about 95% of the variance of relative yields being due to revisions to expected inflation.

Suggested Citation

  • David Barr & Bahram Pesaran, 1995. "An assessment of the relative importance of real interest rates, inflation and term premia in determining the prices of real and nominal UK bonds," Bank of England working papers 32, Bank of England.
  • Handle: RePEc:boe:boeewp:32
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    File URL: http://www.bankofengland.co.uk/archive/Documents/historicpubs/workingpapers/1995/wp32.pdf
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    References listed on IDEAS

    as
    1. Quah, Danny & Vahey, Shaun P, 1995. "Measuring Core Inflation?," Economic Journal, Royal Economic Society, vol. 105(432), pages 1130-1144, September.
    2. Andrew Derry & Mahmood Pradhan, 1993. "Tax Specific Term Structures of Interest Rates in the UK Government Bond Market," Bank of England working papers 11, Bank of England.
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    4. Roger Beaton & Paul Fisher, 1995. "The Construction of RPIY," Bank of England working papers 28, Bank of England.
    5. Mike Joyce, 1995. "Modelling UK Inflation Uncertainty: The Impact of News and the Relationship with Inflation," Bank of England working papers 30, Bank of England.
    6. Paul Fisher & Suzanne Hudson & Mahmood Pradhan, 1993. "Divisia Indices for Money: An Appraisal of Theory and Practice," Bank of England working papers 9, Bank of England.
    7. Campbell, John Y., 1987. "Stock returns and the term structure," Journal of Financial Economics, Elsevier, vol. 18(2), pages 373-399, June.
    8. Jo Corkish & David Miles, 1994. "Inflation, inflation risks and asset returns," Bank of England working papers 27, Bank of England.
    9. Andrew G Haldane & Mahmood Pradhan, 1992. "Real interest parity, dynamic convergence and the European Monetary System," Bank of England working papers 1, Bank of England.
    10. Mishkin, Frederic S., 1992. "Is the Fisher effect for real? : A reexamination of the relationship between inflation and interest rates," Journal of Monetary Economics, Elsevier, vol. 30(2), pages 195-215, November.
    11. Joanna Paisley, 1994. "A Model of Building Society Interest Rate Setting," Bank of England working papers 22, Bank of England.
    12. Paul Fisher & Juna Vega, 1993. "An Empirical Analysis of M4 in the United Kingdom," Bank of England working papers 21, Bank of England.
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    Cited by:

    1. Svensson, Lars E. O., 1997. "Inflation forecast targeting: Implementing and monitoring inflation targets," European Economic Review, Elsevier, vol. 41(6), pages 1111-1146, June.
    2. Andy Haldane & Bennett McCallum & Chris Salmon, 1996. "Base Money Rules in the UK," Bank of England working papers 45, Bank of England.
    3. Francis Breedon & Ian Twinn, 1995. "Valuation of underwriting agreements for UK rights issues: evidence from the traded option market," Bank of England working papers 39, Bank of England.
    4. Marco Rossi, 1996. "The information content of the short end of the term structure of interest rates," Bank of England working papers 55, Bank of England.
    5. Mauricio Larraín E. & Fernando Parro G., 2006. "La Información Contenida en los Movimientos de las Tasas Forward en Chile," Notas de Investigación Journal Economía Chilena (The Chilean Economy), Central Bank of Chile, vol. 9(3), pages 125-132, December.
    6. Martin D. D. Evans, 2003. "Real risk, inflation risk, and the term structure," Economic Journal, Royal Economic Society, vol. 113(487), pages 345-389, April.
    7. Clive Briault & Andrew Haldane & Mervyn A. King, 1997. "Independence and Accountability," Palgrave Macmillan Books, in: Iwao Kuroda (ed.), Towards More Effective Monetary Policy, chapter 10, pages 299-340, Palgrave Macmillan.
    8. Charles Nolan & Eric Schaling, 1996. "Monetary Policy Uncertainty and Central Bank Accountability," Bank of England working papers 54, Bank of England.
    9. Marco Bianchi & Gylfi Zoega, 1998. "Unemployment persistence: does the size of the shock matter?," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 13(3), pages 283-304.
    10. Spencer Dale & Marco Rossi, 1996. "A Market for Intra-day Funds: Does it Have Implications for Monetary Policy?," Bank of England working papers 46, Bank of England.
    11. Juan Ayuso Huertas, 1996. "Un análisis empírico de los tipos de interés reales ex-ante en España," Investigaciones Economicas, Fundación SEPI, vol. 20(3), pages 321-338, September.
    12. Nicola Anderson & Francis Breedon, 1996. "UK Asset Price Volatility Over the Last 50 Years," Bank of England working papers 51, Bank of England.
    13. Marco Bianchi, 1996. "A Comparison of Methods for Seasonal Adjustment of the Monetary Aggregates," Bank of England working papers 44, Bank of England.
    14. Francis Breedon & Jag Chadha, 1997. "The Information Content of the Inflation Term Structure," Bank of England working papers 75, Bank of England.
    15. Martin Evans, 1998. "Looking Behind the U. K.Term Structure: Were there Peso Problems in Inflation?," Finance 9809001, University Library of Munich, Germany.
    16. Matthew B Canzoneri & Charles Nolan & Anthony Yates, 1996. "Feasible Mechanisms for Achieving Monetary Stability: a Comparison of Inflation Targeting and the ERM," Bank of England working papers 52, Bank of England.
    17. Andrew G Haldane, 1995. "Rules, Discretion and the United Kingdom's New Monetary Framework," Bank of England working papers 40, Bank of England.
    18. Francis Breedon, 1996. "Why do the LIFFE and DTB bund futures contracts trade at different prices?," Bank of England working papers 57, Bank of England.

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