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