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Inflation expectations from index-linked bonds: Correcting for liquidity and inflation risk premia

  • Kajuth, Florian
  • Watzka, Sebastian

We provide a critical assessment of the method used by the Cleveland Fed to correct expected inflation derived from index-linked bonds for liquidity and inflation risk premia and show how their method can be adapted to account for time-varying inflation risk premia. Furthermore, we show how sensitive the Cleveland Fed approach is to different measures of the liquidity premium. In addition we propose an alternative approach to decompose the bias in inflation expectations derived from index-linked bonds using a state-space estimation. Our results show that once one accounts for time-varying liquidity and inflation risk premia current 10-year U.S. inflation expectations are lower than estimated by the Cleveland Fed.

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Paper provided by University of Munich, Department of Economics in its series Discussion Papers in Economics with number 4858.

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Date of creation: 10 Jul 2008
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Handle: RePEc:lmu:muenec:4858
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  1. Refet S. Gürkaynak & Brian Sack & Jonathan H. Wright, 2006. "The U.S. Treasury yield curve: 1961 to the present," Finance and Economics Discussion Series 2006-28, Board of Governors of the Federal Reserve System (U.S.).
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  3. Stephen Leybourne & Tae-Hwan Kim & Vanessa Smith & Paul Newbold, 2003. "Tests for a change in persistence against the null of difference-stationarity," Econometrics Journal, Royal Economic Society, vol. 6(2), pages 291-311, December.
  4. Joseph G. Haubrich & George Pennacchi & Peter Ritchken, 2008. "Estimating real and nominal term structures using Treasury yields, inflation, inflation forecasts, and inflation swap rates," Working Paper 0810, Federal Reserve Bank of Cleveland.
  5. Fama, Eugene F. & Gibbons, Michael R., 1982. "Inflation, real returns and capital investment," Journal of Monetary Economics, Elsevier, vol. 9(3), pages 297-323.
  6. García, Juan Angel & Werner, Thomas, 2010. "Inflation risks and inflation risk premia," Working Paper Series 1162, European Central Bank.
  7. Söderlind, Paul, 2009. "Inflation Risk Premia and Survey Evidence on Macroeconomic Uncertainty," CEPR Discussion Papers 7250, C.E.P.R. Discussion Papers.
  8. Dimitri Vayanos & Pierre-Olivier Weill, 2007. "A search-based theory of the on-the-run phenomenon," LSE Research Online Documents on Economics 24474, London School of Economics and Political Science, LSE Library.
  9. Peter Hördahl & Oreste Tristani, 2010. "Inflation risk premia in the US and the euro area," BIS Working Papers 325, Bank for International Settlements.
  10. Stefania D'Amico & Don H Kim & Min Wei, 2008. "Tips from TIPS: the informational content of Treasury Inflation-Protected Security prices," BIS Working Papers 248, Bank for International Settlements.
  11. Hördahl, Peter & Tristani, Oreste, 2007. "Inflation risk premia in the term structure of interest rates," Working Paper Series 0734, European Central Bank.
  12. Kajuth, Florian & Watzka, Sebastian, 2011. "Inflation expectations from index-linked bonds: Correcting for liquidity and inflation risk premia," Munich Reprints in Economics 19535, University of Munich, Department of Economics.
  13. Refet S. Gürkaynak & Brian Sack & Jonathan H. Wright, 2008. "The TIPS yield curve and inflation compensation," Finance and Economics Discussion Series 2008-05, Board of Governors of the Federal Reserve System (U.S.).
  14. Juan Angel Garcia & Adrian van Rixtel, 2007. "Inflation-linked bonds from a Central Bank perspective," Occasional Paper Series 62, European Central Bank.
  15. Dean Croushore, 1993. "Introducing: the survey of professional forecasters," Business Review, Federal Reserve Bank of Philadelphia, issue Nov, pages 3-15.
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