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The Information Content of the Inflation Term Structure

  • Francis Breedon
  • Jag Chadha

This paper examines the information content of inflation forecasts derived using index- linked and conventional bonds. The paper finds that the derived inflation term structure (ITS) gives a somewhat better indication of the bond market's inflation expectation than can be derived using either the nominal term structure or a variant employing strong assumptions about real interest rate behaviour. The inflation forecasts of the ITS also seem at least as good at forecasting future changes in inflation as forecasts derived from macroeconometric models. These characteristics of the ITS and its timeliness tend to make its inflation forecasts a useful addition to policy analysis. Because the real term structure tends to underpredict the level of future real interest rates, index-linked bonds have proved, ex post, to be cheap funding for the UK government. But we cannot be sure whether this underprediction results from an inflation risk premium or expectational error and also cannot know whether this overprediction will persist.

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Paper provided by Bank of England in its series Bank of England working papers with number 75.

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Date of creation: Dec 1997
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Handle: RePEc:boe:boeewp:75
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  1. Robert J. Barro, 1995. "Optimal Debt Management," NBER Working Papers 5327, National Bureau of Economic Research, Inc.
  2. Soderlind, P., 1995. "Forward Interest Rates as Indicators of Inflation Expectations," Papers 594, Stockholm - International Economic Studies.
  3. David G. Barr & John Y. Campbell, 1996. "Inflation, Real Interest Rates, and the Bond Market: A Study of UK Nominal and Index-Linked Government Bond Prices," NBER Working Papers 5821, National Bureau of Economic Research, Inc.
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  10. Jeffrey A. Frankel & Cara S. Lown, 1991. "An Indicator of Future Inflation Extracted From the Steepness of the Interest Rate Yield Curve Along Its Entire Length," NBER Working Papers 3751, National Bureau of Economic Research, Inc.
  11. Frankel, Jeffrey A, 1982. "A Technique for Extracting a Measure of Expected Inflation from the Interest Rate Term Structure," The Review of Economics and Statistics, MIT Press, vol. 64(1), pages 135-42, February.
  12. Kandel, Shmuel & Ofer, Aharon R & Sarig, Oded, 1996. " Real Interest Rates and Inflation: An Ex-Ante Empirical Analysis," Journal of Finance, American Finance Association, vol. 51(1), pages 205-25, March.
  13. Frederic S. Mishkin, 1991. "Is the Fisher Effect for Real? A Reexamination of the Relationship Between Inflation and Interest Rates," NBER Working Papers 3632, National Bureau of Economic Research, Inc.
  14. Nelson, Charles R & Siegel, Andrew F, 1987. "Parsimonious Modeling of Yield Curves," The Journal of Business, University of Chicago Press, vol. 60(4), pages 473-89, October.
  15. 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.
  16. John Y. Campbell & Robert J. Shiller, 1996. "A Scorecard for Indexed Government Data," Harvard Institute of Economic Research Working Papers 1758, Harvard - Institute of Economic Research.
  17. John Y. Campbell & Robert J. Shiller, 1996. "A Scorecard for Indexed Government Debt," NBER Working Papers 5587, National Bureau of Economic Research, Inc.
  18. Fischer, Stanley, 1975. "The Demand for Index Bonds," Journal of Political Economy, University of Chicago Press, vol. 83(3), pages 509-34, June.
  19. N. Gregory Mankiw, 1986. "The Term Structure of Interest Rates Revisited," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 17(1), pages 61-110.
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