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What do the prices of UK inflation-linked securities say on inflation expectations, risk premia and liquidity risks?

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  • Kaminska, Iryna
  • Liu, Zhuoshi
  • Relleen, Jon
  • Vangelista, Elisabetta

Abstract

The difference between yields on nominal and inflation-linked government bonds or inflation swap rates are important indicators of the outlook for inflation and are monitored regularly by central banks, including the United Kingdom's Monetary Policy Committee (MPC). However, in the United Kingdom, inflation-linked instruments reference RPI inflation, whereas the MPC's target is CPI inflation of 2%. In this paper we extract market expectations for UK CPI inflation with the help of UK RPI-linked gilt prices, which is a novelty in the literature. To better extract useful information about expectations for CPI inflation, we develop a no-arbitrage term structure model and decompose the forward inflation curve into: measures of CPI inflation expectations; the expected wedge between RPI and CPI inflation; estimates of inflation risk premia and estimates of liquidity risk premia. We show that long-horizon expectations of CPI inflation fell in the 1990 s, after the introduction of inflation targeting and the creation of the MPC, and have since remained fairly stable at around 2%.

Suggested Citation

  • Kaminska, Iryna & Liu, Zhuoshi & Relleen, Jon & Vangelista, Elisabetta, 2018. "What do the prices of UK inflation-linked securities say on inflation expectations, risk premia and liquidity risks?," Journal of Banking & Finance, Elsevier, vol. 88(C), pages 76-96.
    • Handle: RePEc:eee:jbfina:v:88:y:2018:i:c:p:76-96
    DOI: 10.1016/j.jbankfin.2017.09.015
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    References listed on IDEAS

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    Cited by:

    1. Berardi, Andrea & Plazzi, Alberto, 2022. "Dissecting the yield curve: The international evidence," Journal of Banking & Finance, Elsevier, vol. 134(C).
    2. Marcello Pericoli, 2019. "An assessment of recent trends in market-based expected iflation in the euro area," Questioni di Economia e Finanza (Occasional Papers) 542, Bank of Italy, Economic Research and International Relations Area.
    3. Andras Lengyel, 2022. "Treasury Supply Shocks and the Term Structure of Interest Rates in the UK," MNB Working Papers 2022/6, Magyar Nemzeti Bank (Central Bank of Hungary).
    4. Huang, Xiaoyong & Jia, Fei & Xu, Xiangyun & Yu shi,, 2019. "The threshold effect of market sentiment and inflation expectations on gold price," Resources Policy, Elsevier, vol. 62(C), pages 77-83.
    5. Helder Ferreira de Mendonça & Pedro Mendes Garcia & José Valentim Machado Vicente, 2021. "Rationality and anchoring of inflation expectations: An assessment from survey‐based and market‐based measures," Journal of Forecasting, John Wiley & Sons, Ltd., vol. 40(6), pages 1027-1053, September.
    6. Berardi, Andrea, 2023. "Term premia and short rate expectations in the euro area," Journal of Empirical Finance, Elsevier, vol. 74(C).
    7. Barria, Rodrigo & Pinter, Gabor, 2023. "Mispricing in inflation markets," Bank of England working papers 1034, Bank of England.

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    More about this item

    Keywords

    Affine arbitrage-free dynamic term structure model; Breakeven inflation; Inflation expectations; Risk premia; Funding liquidity; Survey expectations;
    All these keywords.

    JEL classification:

    • C40 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - General
    • 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
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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