Breakeven Inflation Research Articles

The impact of liquidity on inflation-linked bonds: A hypothetical indexed bonds approach

Sovereigns mainly issue inflation-linked bonds (ILB) in order to save money. More than 15 years’ experience with this financial instrument in the United States has led to the conclusion that these bonds are characterized by low liquidity issues. Recently, various papers have started to analyze the impact of liquidity on ILB yields. This paper develops a new strategy for estimating the liquidity premium based on Campbell and Shiller's (1996) hypothetical ILB yields. We find significant effects of ILB-specific liquidity measures for the United States, the United Kingdom and Canada. Based on these findings, we derive the liquidity premium in ILB yields, liquidity-adjusted estimates for the break-even inflation rate and the inflation risk premium. In the United States, for instance, the average of the liquidity premium is 0.56%-points, and the average liquidity-adjusted break-even inflation rate and inflation risk premium amount to 2.67%-points and 0.22%-points, respectively.

Reactions of real yields and inflation expectations to forward guidance in the United States

We study the impact of forward policy rate guidance by the Federal Reserve’s Federal Open Market Committee (FOMC) used as an unconventional monetary policy tool at the zero lower bound of the policy rate on real and breakeven US Treasury yield curves. We find that explicit FOMC policy rate guidance announcements led to a significant reduction in real yields at horizons of 2 to 5 years ahead. By contrast, long-term breakeven inflation rates were little affected, suggesting that inflation expectations have remained well anchored, and that explicit FOMC policy rate guidance has not adversely affected central bank credibility.

How Much Do Oil Prices Affect Inflation?

It is puzzling why large monthly or quarterly oil price changes predict very small changes in the CPI but daily oil prices predict large changes in breakeven inflation.

Decompondo a Inflação Implícita

A inflacao implicita (diferenca entre as taxas de juros nominal e real) e o principal indicador do nivel futuro de precos. No entanto, a expectativa de inflacao e apenas um dos seus componentes. Neste artigo nos apresentamos um modelo economico simples a fim de decompor a inflacao implicita nos seguintes fatores fundamentais: expectativa de inflacao, termo de convexidade e premios de liquidez e de risco de inflacao. Usando dados brasileiros de janeiro de 2006 a setembro de 2013, avaliamos cada um destes termos. As expectativas de inflacao sao lidas diretamente do Focus, uma pesquisa realizada pelo Banco Central do Brasil. Em nosso modelo, o termo de convexidade ou correcao de Jensen e igual a variância da taxa de inflacao. Reportamos um termo de convexidade muito pequeno, o que esta em consonância com a literatura internacional sobre o assunto. Sua magnitude e de cerca de um ponto base, inferior ao spread de compra e venda dos titulos de renda fixa brasileiros. Embora haja uma diferenca significativa entre os volumes de negociacao de titulos nominais e reais, essa diferenca de liquidez nao e aprecada (premio de liquidez nao e significativo). Este resultado, aparentemente contraditorio, ocorre porque no Brasil titulos reais sao geralmente mantidos ate o vencimento. Por isso os investidores nao exigem uma recompensa devido a exposicao a incerteza de liquidez, o que por sua vez elimina a relevância deste premio. Finalmente, nos mostramos que o premio de risco de inflacao e pequeno para horizontes curtos. Para horizontes longos este premio de risco e variavel no tempo e relacionado com o consumo e a volatilidade do mercado de acoes, em acordo com a teoria economica.

Assessing the anchoring of inflation expectations

This paper proposes a new approach to assess the degree of anchoring of inflation expectations. We extend the static setup of the predominant news regressions by introducing exponential smooth transition autoregressive dynamics. Our approach provides estimates of a market-perceived inflation target as well as the strength of the anchor that holds expectations at that target. A cross-country study based on a new data set of daily break-even inflation rates for the US, EMU, UK and Sweden shows that the degree of anchoring varies substantially across countries and expectations horizons.

On the reliability of Japanese inflation expectations using purchasing power parity

This paper shows how purchasing power parity (PPP) can be used to construct a measure for inflation expectations and discusses the properties of this measure from both a theoretical and an empirical perspective. Under the PPP hypothesis, inflation expectations in one country are equal to inflation expectations in another country plus the expected depreciation rate of the nominal exchange rate. Exploiting this formula, we calculate Japanese inflation expectations from the break-even inflation rates (BEI) and FX forward spreads for five countries (United States, United Kingdom, Australia, Canada, and Sweden). The resulting PPP-based measure of inflation expectations follows a trend that largely coincides with long-run developments in the Japanese BEI. However, we find that both levels of and variations in the new measure differ across the reference countries, and that a recent gap between the new measure and the Japanese BEI is not negligible from a short-run perspective. Consequently, there remain several issues that need to be addressed to assess the usefulness of this new formula.

Structural Analysis with Independent Innovations

Structural innovations in multivariate dynamic systems are typically hidden and often identified by means of a-priori economic reasoning. Under multivariate Gaussian model innovations there is no loss measure available to distinguish alternative orderings of variables or, put differently, between particular identifying restrictions and rotations thereof. Based on a non Gaussian framework of independent innovations, a loss statistic is proposed in this paper that allows to discriminate between alternative identifying assumptions on the basis of nonparametric density estimates. The merits of the proposed identification strategy are illustrated by means of a Monte Carlo study. Real data applications cover bivariate systems comprising US stock prices and total factor productivity, and four couples of international breakeven inflation rates to investigate monetary autonomy of the Bank of Canada and the Bank of England.

World Economic Prospects

Overview: What do falling bond yields tell us? US bond yields have fallen considerably since the start of the year – by about 40bp for 10‐year bonds – a development apparently at odds with expectations of stronger US growth this year and next and with the process of Fed ‘tapering’. There are several possible explanations, some of which tie in with our global forecast story. Recent US growth data have been largely disappointing, with GDP barely expanding in Q1. This month sees our forecast for growth in 2014 cut to 2.4% from 2.9%. But we expect a solid rebound in growth from Q2, in line with most observers. This suggests other factors are at work – including factors outside the US. First, the US bond market seems to have taken a ‘sell on the rumour, buy on the fact’ attitude to tapering. This may reflect a view that tapering will lead to falls in prices of risky assets, and also perhaps indicates Fed success in managing its forward guidance. Notably, one‐year interest rates have drifted lower since Q3 2013: the market has pushed away expectations of early Fed rate hikes. Second, long‐term inflation expectations are stable or declining in most advanced economies. US expectations have hovered around 2% in recent months (down from 2.5% a year ago) while inflation expectations in the Eurozone have declined notably: 10‐year breakeven inflation in France is just 1.1%. Our growth forecast in the Eurozone has edged up in recent months but remains low, implying the negative output gap will remain wide and disinflationary pressures continue. And emerging markets are set to add to the global negative output gap. PMI surveys show continued weak growth and this month sees some further GDP forecast downgrades in the BRICs. Taken together, these factors suggest that bond markets are pricing modest economic growth and low inflation, broadly in line with our forecast. But there are significant nodes of downside risk in the Eurozone and the Chinese financial sector. The ECB seems likely to act next month but how decisive it will be is unclear. Whether the authorities in China can contain financial sector risks also remains an open question.

It Takes a Regime Shift: Recent Developments in Japanese Monetary Policy through the Lens of the Great Depression

Last week, we witnessed one of the most exciting developments in monetary policymaking since the 1930s. The Japanese central bank staged an honest-to-goodness regime shift. The Bank of Japan went beyond vague promises and cheap talk. As I will describe in more detail later, it took dramatic actions and pledged convincingly to do whatever it takes to end deflation in Japan. The theoretical reasons why this regime shift may be important are well understood by economists. Persistent deflation and anemic growth suggest that Japan continues to suffer from a shortfall of demand. But their policy interest rate is already at the zero lower bound. Furthermore, riskier, long-term rates are also very low— suggesting that unconventional policies such as large-scale asset purchases are unlikely to do much to further reduce nominal rates. As discussed by Paul Krugman, Gauti Eggertsson and Michael Woodford, and others, if unconventional monetary policy can raise expected inflation, this can push down real interest rates even though nominal rates cannot fall. 1 This, in turn, can raise aggregate demand by stimulating interest

Inflação implícita e o prêmio pelo risco: uma alternativa aos modelos VAR na previsão para o IPCA

O presente artigo avalia, para o caso brasileiro, se a inflação implícita extraída dos títulos de renda fixa constitui um estimador não viesado da inflação ao consumidor, medida pelo IPCA. Nossas estimativas sugerem que as break-even inflation rates - ou simplesmente BEIRs - trazem informação relevante a respeito da inflação futura, especialmente para a maturidade de três meses. A principal inovação de nosso trabalho, contudo, está no método utilizado para a estimação, que nos permite concluir que o prêmio de risco da inflação, para algumas das maturidades consideradas, varia ao longo do tempo e não é desprezível do ponto de vista econômico. Comparamos também as previsões de inflação obtidas a partir das BEIRs com os modelos VAR utilizados pelo Banco Central e as estimativas dos Top5 do Relatório Focus. As previsões realizadas com as BEIRs mostraram maior acurácia que aquelas extraídas dos modelos VAR, porém, menos precisas que as geradas pelos Top5.

Break-Even Inflation Rate and the Risk Premium: An Alternative Approach to the VAR Models in Forecasting the CPI

This paper examines, for the Brazilian case, if break-even inflation rates (BEIR) extracted from fixed income securities are an unbiased estimator of consumer inflation, measured by the CPI. Our estimates suggest that BEIRs are informative about future inflation, especially for the maturity of three months. The main innovation of our work, however, is the method used for estimation, allowing us to conclude that the inflation risk premium, for some maturities considered, varies over time and is not irrelevant from the economic standpoint. We also compared the inflation forecasts obtained from BEIRs with the ones extracted from VAR models used by Central Bank and estimates from the Focus Survey Report's Top5s. The forecasts performed with BEIRs showed greater accuracy than those extracted from VAR models. These projections, however, underperformed those from the Top5s.

Prima de riesgo por inflación calculada con el Break-Even Inflation y el modelo dinámico Nelson-Siegel

En la presente investigación, que se enmarca dentro de la economía y las finanzas, se estima la prima de riesgo por inflación para Colombia a partir de las expectativas de inflación proporcionadas por el indicador Break Even Inflation (BEI). Los modelos utilizados en estudios anteriores de este tipo son estructuralmente complejos en la medida que no son parsimoniosos, pues el número de parámetros a estimar es alto y de difícil comprensión y se concentran en la medición de las expectativas de inflación. Adicional a lo anterior, todos ellos requieren información primaria acerca del comportamiento de las expectativas de inflación a partir de las encuestas realizadas por los bancos centrales. La metodología usada es el filtro Kalman con una representación estado espacio para la ecuación dinámica de Nelson y Siegel. Los datos utilizados son los rendimientos de los títulos nominales y de los títulos indexados a la inflación para el período enero 2003 a septiembre 2010, información pública proporcionada por la Bolsa de Valores de Colombia. Los resultados muestran que la prima de riesgo por inflación para un plazo de cinco años es de 53 puntos básicos.

Do inflation-linked bonds contain information about future inflation?

There is a widespread belief that inflation-linked bonds are a direct source of information about inflation expectations. In this paper we address this issue by analyzing the relationship between break-even inflation (the difference between nominal and real yields) and future inflation. The dataset is extracted from Brazilian Treasury bonds covering the period from April 2005 to April 2011. We find that break-even inflation is an unbiased forecast only of the 3-month and 6-month ahead inflation. For medium horizons (12 and 18 months), break-even inflation has weak explanatory power of future inflation. Over long horizons (24 and 30 months), we report a significant, but counterintuitive, negative relationship between the break-even and realized inflation rates.

An Ex Post Performance Analysis of the TIPS Program

This article extends the methodology in Sack and Elsasser [2004] and Roush [2007] to define and measure the performance of the Treasury inflation-protected securities (TIPS) program in terms of the relative cost over issuing equivalent nominal securities. The relative cost is driven by the change of the breakeven inflation and, in particular, that of the liquidity-adjusted inflation risk premium when the inflation expectation is stable. We use all 96 TIPS issuances since the inception of the program (January 1997) to June 2012 to calculate a 185-month time series of relative costs at CUSIP and aggregate levels. As of June 2012, we find that the TIPS program has accumulated a relative saving of $7.06 billion. If past is prologue, we would expect relative savings from the TIPS program to continue.

New tips from TIPS: Identifying inflation expectations and the risk premia of break-even inflation

Abstract This paper decomposes the break-even inflation rates derived from inflation-indexed bonds into inflation risk premia, liquidity risk premia, and inflation expectations. I estimate a common factor model with autoregressive conditionally heteroscedastic (ARCH) errors that extracts co-movements from twenty-two monthly and quarterly indicators to identify these three components. The results indicate that the sharp declines in the 10-year and 5-year break-even inflation rates in 2009 reflect a substantial increase in liquidity risk rather than a decrease in inflation expectations. Break-even inflation rates underestimate inflation expectations over nearly the entire sample due to the liquidity risk premia carried by the inflation indexed bond yields. Also, the model-implied inflation expectations show better forecast performance for the average annual inflation rates than raw break-even inflation rates, the Survey of Professional Forecasters, and the Surveys of Consumers inflation forecasts.

Inflation breakeven in the Jarrow and Yildirim model and resulting pricing formulas

The Jarrow and Yildirim model for pricing inflation-indexed derivatives is still the main reference technique adopted in the inflation market. Despite its popularity it has some shortcomings, the most immediate of which is the difficulty of calibrating to market prices of options due to the large number of parameters involved. Since the market trades options on the inflation rate or index, we reformulate their model in terms of the notion of breakeven inflation. The first main advantage is the possibility of describing the prices of the most popular inflation derivatives as functions of just three parameters: breakeven volatility, the volatility of the CPI price index and the correlation between them. Secondly, the resulting Black–Scholes-implied volatilities are very straightforward to implement and the geometric interpretation of the model makes it intuitive to calibrate. Lastly, the model permits us to reproduce a realistic picture of the current state of the art of the derivatives market and, in particular, due to its simplicity, it is able to estimate the risk premium priced by the inflation market.

Price discovery on traded inflation expectations: does the financial crisis matter?

We analyze contributions of different markets, related by an approximate arbitrage relationship, to price discovery on traded inflation expectations and how it changed during the financial crisis. We use a new high-frequency data-set on inflation-indexed and nominal government bonds as well as inflation swaps to calculate information shares of break-even inflation rates in the euro area and the USA. In the euro area, for maturities up to 5 years new information comes from both the swap and the bond markets. For longer maturities, the swap market provides less and less information in the euro area. In the USA, the bond market dominates the price discovery process for all maturities. The severe financial crisis that spread out in Autumn 2008 drove a wedge between bond and swap break-even inflation rates in both currencies. Price discovery ceased to take place on the swap market. Disruptions coming from the short-end of the market even separated price formation on both segments for maturities of up to 6 years in the USA. Against the backdrop of the most severe financial crisis in decades, contributions to price formation concentrated a lot more on the presumably safest financial instrument: government bonds.

Pricing TIPS and Treasuries with Linear Regressions

We present an affine term structure model for the joint pricing of TIPS and Treasury yield curves that adjusts for TIPS’ relative illiquidity. Our estimation via linear regressions is computationally efficient and can accommodate a large number of pricing factors. The baseline specification with seven principal components extracted from Treasury and TIPS yields as well as a liquidity factor generates negligibly small pricing errors for both real and nominal yields. Model-implied expected inflation adjusted for risk premia and liquidity provides a better prediction of actual inflation than unadjusted breakeven inflation. Analysis of model-implied Treasury and TIPS decompositions shows that the Federal Reserve’s large-scale asset purchases lowered nominal and real Treasury yields primarily via a reduction of real term premia, the compensation investors demand for bearing real short-rate risk. Real term premia also account for the large response of long-term real forward rates to monetary policy surprises. The deflation floor embedded in TIPS is generally small in magnitude, but spiked during the recent crisis. We also show that the nominal and real term structures from the United Kingdom have qualitatively similar features to the U.S. yields.

Disagreement About Inflation and the Yield Curve

We show theoretically that inflation disagreement drives a wedge between real and nominal yields and raises their levels and volatilities. We demonstrate empirically that an inflation disagreement increase of one standard deviation raises real and nominal yields and their volatilities, break-even inflation, and the inflation risk premium by at least 30% of their respective standard deviations. Inflation disagreement is positively related to consumers’ cross-sectional consumption growth volatility and trading in bonds, interest rate futures, and inflation swaps. Calibrating the model to disagreement, inflation, and yield data reproduces the economically significant impact of inflation disagreement on real and nominal yield curves.

INFLATION RISK PREMIA IN THE TERM STRUCTURE OF INTEREST RATES

This paper estimates the size and dynamics of inflation risk premia in the euro area, based on a joint model of macroeconomic and term structure dynamics. Information from both nominal and index-linked yields is used in the empirical analysis. Our results indicate that the inflation risk premium on euro area 10-year nominal yields was approximately equal to 20 basis points on average over the 1999–2007 period. The inflation premium has also been subject to moderate, but statistically significant fluctuations. For the post-2003 period in which reliable index-linked bond prices are available, our results suggest that increases in the raw break-even inflation rate above 2%, the upper bound of the European Central Bank's definition for price stability, have mostly reflected variations in the inflation risk premium, while long-term inflation expectations have remained well anchored.