Nominal and Inflation Indexed Yields: Separating Expected Inflation and Inflation Risk Premia

Abstract

This research makes joint use of the prices of nominal and inflation indexed bonds to estimate and study inflation risk premium and inflation expectations. First, I use a robust non-parametric procedure on UK data from 1983 to 1999 to extract weekly nominal and inflation indexed zero prices. Then I develop a pricing model in the spirit of the essentially affine class of Duffee (2000). I estimate the model with a Kalman filter and find that the data is best fit by a 4 factor version. The estimates support a variable, mostly significant inflation risk premium; on a 10 year zero coupon bond this is on average 2%, but is initially higher, and eventually indistinguishable from zero; its behavior follows historical events. The variability of the nominal to real yield spread is mostly due to inflation at the short end and to its premium at the long end.