Abstract
This paper focuses on break-even inflation rates (BEIRs), a widely used market-based measure of expected inflation, computed from government bonds. In the first part of the paper, we regress the Italian BEIR on several financial variables to assess the contribution of inflation, credit and liquidity components. In the second, in order to disentangle market participants’ inflation expectations from risk premia, we estimate a term structure model for the joint pricing of the Italian nominal and real yield curves, considering also credit and liquidity factors. The results show that BEIRs could be a misleading measure of the expected inflation due to the importance of inflation risk premium and credit risk effect. According to our estimates, the decrease in market-based measures of inflation observed in the last part of the sample period seems to reflect a lowering of both inflation expectations and risk premia. Inflation premia co-move with a measure of tail risk of the long-term inflation distribution signalling that investors become more concerned with downside risks.
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