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What was the market's view of U.K. monetary policy? Estimating inflation risk and expected inflation with indexed bonds

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  • Eli M. Remolona
  • Michael Wickens
  • Frank F. Gong

Abstract

A measure of the credibility of monetary policy is the inflation risk premium in nominal yields. This will be time varying and can be estimated by combining the information in the nominal term structure with that in the real term structure. We estimate these risk premia using a generalized CIR affine-yield model, with one factor driving the real term structure of monthly observations on two-year, five-year and ten-year UK index-linked debt and two factors driving the term structure of the corresponding nominal yields. Our estimates show that the inflation risk premium contributes on average about 100 basis points to nominal yields. Since the exit from the ERM this has fallen to 70 basis points, showing greater policy credibility. The inflation risk premium provides a correction to the break-even method of forecasting inflation and produces an unbiased forecast.

Suggested Citation

  • Eli M. Remolona & Michael Wickens & Frank F. Gong, 1998. "What was the market's view of U.K. monetary policy? Estimating inflation risk and expected inflation with indexed bonds," Staff Reports 57, Federal Reserve Bank of New York.
  • Handle: RePEc:fip:fednsr:57
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    Cited by:

    1. Kanas, Angelos, 2014. "Bond futures, inflation-indexed bonds, and inflation risk premium," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 28(C), pages 82-99.
    2. Nuno Cassola & Jorge Barros Luis, 2003. "A two-factor model of the German term structure of interest rates," Applied Financial Economics, Taylor & Francis Journals, vol. 13(11), pages 783-806.
    3. Peter Hördahl, 2008. "The inflation risk premium in the term structure of interest rates," BIS Quarterly Review, Bank for International Settlements, September.
    4. Joyce, Michael A.S. & Lildholdt, Peter & Sorensen, Steffen, 2010. "Extracting inflation expectations and inflation risk premia from the term structure: A joint model of the UK nominal and real yield curves," Journal of Banking & Finance, Elsevier, vol. 34(2), pages 281-294, February.
    5. Andrew Ang & Geert Bekaert & Min Wei, 2008. "The Term Structure of Real Rates and Expected Inflation," Journal of Finance, American Finance Association, vol. 63(2), pages 797-849, April.
    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. Smith, Peter & Wickens, Michael, 2002. " Asset Pricing with Observable Stochastic Discount Factors," Journal of Economic Surveys, Wiley Blackwell, vol. 16(3), pages 397-446, July.
    8. Hiona Balfoussia & Mike Wickens, 2006. "Extracting inflation expectations from the term structure: the Fisher equation in a multivariate SDF framework," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 11(3), pages 261-277.
    9. Juan Angel Garcia & Adrian van Rixtel, 2007. "Inflation-linked bonds from a central bank perspective," Occasional Papers 0705, Banco de España;Occasional Papers Homepage.
    10. Peter Hördahl & Oreste Tristani, 2012. "Inflation Risk Premia In The Term Structure Of Interest Rates," Journal of the European Economic Association, European Economic Association, vol. 10(3), pages 634-657, May.
    11. Martin Evans, 1998. "Looking Behind the U. K.Term Structure: Were there Peso Problems in Inflation?," Finance 9809001, EconWPA.
    12. Hans-Jürg Büttler, 2002. "The information content of the yield curve," BIS Papers chapters,in: Bank for International Settlements (ed.), Market functioning and central bank policy, volume 12, pages 298-328 Bank for International Settlements.
    13. Barros Luís, Jorge & Cassola, Nuno, 2001. "A two-factor model of the German term structure of interest rates," Working Paper Series 0046, European Central Bank.
    14. Fung, Ben & Mitnick, Scott & Remolona, Eli, 1999. "Uncovering Inflation Expectations and Risk Premiums From Internationally Integrated Financial Markets," Staff Working Papers 99-6, Bank of Canada.
    15. Madureira, Leonardo, 2007. "The ex ante real rate and inflation premium under a habit consumption model," Journal of Empirical Finance, Elsevier, vol. 14(3), pages 355-382, June.
    16. Ben Siu Cheong Fung & Scott Mitnick & Eli M Remolona, 1999. "Inflation Expectations and Risks in a Two-Country Affine-Yield Model," CGFS Papers chapters,in: Bank for International Settlements (ed.), Market Liquidity: Research Findings and Selected Policy Implications, volume 11, pages 1-23 Bank for International Settlements.

    More about this item

    Keywords

    Inflation (Finance) - Great Britain ; Forecasting ; Risk ; Monetary policy - Great Britain ; Great Britain;

    JEL classification:

    • 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
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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