Inflation Risk Premium Research Articles

Inflation Risk Premia, Yield Volatility, and Macro Factors

AbstractWe incorporate a latent stochastic volatility factor and macroeconomic expectations in an affine model for the term structure of nominal and real rates. We estimate the model over 1999–2016 on U.S. data for nominal and TIPS yields, the realized and implied volatility of T-bonds, and survey forecasts of GDP growth and inflation. We find relatively stable inflation risk premia averaging at 40 basis points at the long-end, and which are strongly related to the volatility factor and conditional mean of output growth. We also document real risk premia that turn negative in the post-crisis period, and a non-negligible variance risk premium.

Inflation Risk Premia, Yield Volatility and Macro Factors

We incorporate a latent stochastic volatility factor and macroeconomic expectations in an affine model for the term structure of nominal and real rates. We estimate the model over 1999-2016 on U.S. data for nominal and TIPS yields, the realized and implied volatility of T-bonds and survey forecasts of GDP growth and inflation. We find relatively stable inflation risk premia averaging at 40bps at the long-end, and which are strongly related to the volatility factor and conditional mean of output growth. We also document real risk premia that turn negative in the post-crisis period, and a non-negligible variance risk premium.

Oil Price, Bond Return, and Breakeven Inflation

Compared with stocks, bonds are more directly affected by fluctuations in oil prices through the expected inflation component in nominal bond yields. Surprisingly, prior literature finds little predictive power of oil price changes on bond excess returns. This finding is counter intuitive, especially given the strong predictive relationship between oil price changes and equity risk premium. Using oil supply, global demand, and oil-specific demand shocks, estimated from a structural VAR model of oil price changes, this paper provides new empirical evidence - the oil price changes driven by global demand shocks predict negative real bond risk premium and positive inflation risk premium. Since these two effects offset each other, we observe insignificant effect on the bond risk premium. A two-sector New Keynesian model shows theoretically that real bond yield, breakeven inflation, and nominal bond yield respond differently to oil supply and demand shocks.

On Aspects of Inflation in the Context of Commodity and Futures Market

This thesis has developed alternative approaches for inflation forecasting and analysed the inflation risk premium in the context of commodity futures and options markets. Chapter 1 proposes an approach to tackle the non-availability of exchange-traded inflation futures price data. The composition of the consumer price index enables us to recognise the commodities which correspond to the consumption goods in the CPI. By averaging the commodity futures prices in the same way as the CPI is composed, we construct a synthetic futures contract written on the consumer price index, i.e. a futures on the CPI proxy, based on which we derive a ‘point’ forecast of inflation rate. Chapter 2 analyses the term structures of futures on the CPI proxy using the Schwartz (1997) method. Inspired by the Schwartz (1997)’s framework, we develop a two-factor valuation model filtering the spot consumer price index and the instantaneous real interest rate. The Kalman filter is applied to estimate the two-factor valuation model parameters. The filtered spot consumer price index may help alleviate the publication lag in the U.S. CPI-U index. What’s more, the two-factor valuation model is capable of forecasting the downward trend in the U.S. CPI inflation rate during May 2014 to December 2014. Chapter 3 forecasts the inflation rate from the perspective of commodity futures option market. We construct a synthetic option contract written on the futures on the CPI proxy. Based on a synthetic option implied volatility surface, we derive an interval estimate for the one-year ahead expected inflation rate. Moreover, the fact that commodity futures option market data is high-frequency enables our method of inflation forecasting to theoretically capture the market expectation of price level evolution in the real time. Chapter 4 estimates the inflation risk premium using commodity market data. We derive a link between the inflation risk premium and the risk premium associated with the futures on the CPI proxy. The negative inflation risk premium estimates in our result are consistent with the recent inflation risk premium estimates in the macroeconomic inflation risk premium literature.

Why Does the Yield-Curve Slope Predict Recessions?

Why is an inverted yield-curve slope such a powerful predictor of future recessions? We show that a decomposition of the yield curve slope into its expectations and risk premia components helps disentangle the channels that connect fluctuations in Treasury rates and the future state of the economy. In particular, a change in the yield curve slope due to a monetary policy easing, measured by the current real-interest rate level and its expected path, is associated with an increase in the probability of a future recession within the next year. In contrast, a decrease in risk premia is associated with either a higher or lower recession probability, depending on the source of the decline. In recent years, a decrease in the inflation risk premium slope has been accompanied by a heightened risk of recession, while a lower real-rate risk premium slope is a signal of diminished recession probabilities. This means that not all declines in the yield curve slope are bad news for the economy, and not all instances of steepening are good news either.

Why does the yield-curve slope predict recessions?

Why is an inverted yield-curve slope such a powerful predictor of future recessions? We show that a decomposition of the yield curve slope into its expectations and risk premia components helps disentangle the channels that connect fluctuations in Treasury rates and the future state of the economy. In particular, a change in the yield curve slope due to a monetary policy easing, measured by the current real-interest rate level and its expected path, is associated with an increase in the probability of a future recession within the next year. In contrast, a decrease in risk premia is associated with either a higher or lower recession probability, depending on the source of the decline. In recent years, a decrease in the inflation risk premium slope has been accompanied by a heightened risk of recession, while a lower real-rate risk premium slope is a signal of diminished recession probabilities. This means that not all declines in the yield curve slope are bad news for the economy, and not all instances of steepening are good news either.

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

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%.

Measuring inflation expectations in Russia using stock market data

This paper is devoted to the measurement of inflation expectations in Russia based on stock market data for the period from July 2015 to December 2016. It calculates the difference between the yields of the nominal and inflation-indexed government bonds and adjusts it to the inflation risk premium and liquidity risk premium to obtain inflation expectations. This net indicator represents inflation expectations of the participants of the stock market. The estimated inflation expectations can be used to analyze the effectiveness of the information policy.

When Is It Cheaper to Issue Inflation-Linked Debt?

I compare the direct issuance costs of inflation-linked debt (the liquidity premium) with nominal government debt (the inflation risk premium) in developed countries. On average, it is cheaper to issue nominal debt at medium maturities (5-10 years) and inflation-linked debt at long maturities (20 or more years), although results vary somewhat based on whether survey-based or statistical inflation expectations are used. Issuance costs exhibit pronounced time and cross-country variation. Lower inflation-linked debt issuance costs are associated with more countercyclical inflation and higher proportions of inflation-linked debt. International inflation-linked zero-coupon yields are available as an Internet Appendix to this paper.

Disagreement in expectations about public debt, monetary policy credibility and inflation risk premium

This paper analyzes the determinants of the inflation risk premium in Brazil during the Inflation Targeting period. In particular, different from the existing studies, we analyze the influence of both public debt expectations and disagreement in expectations about public debt on the inflation risk premium, and also the effect of monetary policy credibility on the inflation risk premium. The findings bring two important policy implications. One related to the effect of the expectations formed for the commitment of the government with debt management; and the other related to the effect of the expectations formed for the central bank’s commitment with the Inflation Targeting regime. The results suggest the disagreement in expectations about the public debt affects the inflation risk premium. Furthermore, the findings also suggest the degree of anchorage of inflation expectations in relation to the inflation target (i.e., the monetary policy credibility) affects the inflation risk premium.

How do zero-coupon inflation swaps predict inflation rates in the euro area? Evidence of efficiency and accuracy on 1-year contracts

This paper examines the risk-neutral efficient market hypothesis for inflation swap markets in the euro area from 2005.10 to 2014.07. Overall, we conclude that 1-year zero-coupon inflation swap rates are unbiased predictors of inflation rates. Further, there is no empirical evidence of an inflation risk premium and the assumption of rationality seems to hold. Definitely, these inferences encourage the reading of inflation expectations embedded in short-term inflation swaps. Additionally, we compare the predictive ability of inflation swaps with other measures of inflation expectations. The in-sample results show that, in contrast with surveys, market-based measures are able to accurately forecast inflation rates. In turn, based on an out-of-sample analysis, a straightforward econometric model dominates other sources. Therefore, a combined analysis that uses different sources contributes to a more robust view of future inflation rates.

International Real Yields

I study market-implied real yields extracted from prices of inflation-linked government bonds for nine developed countries. The liquidity premium is an important component of breakeven inflation rates. Unconditional real yield curves are upward-sloping, providing empirical support for habit models. The cross-country real rate equality is rejected. Across countries, real yields are strongly positively correlated while liquidity premia are moderately positively correlated. Low nominal yields following the Great Recession are mainly due to low real yields, although the inflation risk premia have also decreased.

Disagreement in Inflation Forecasts and Inflation Risk Premia in Brazil

The aim of this study is to investigate the link between the inflation uncertainty and the inflation risk premia implied by the term structures of nominal and real interest rates in Brazil. We gauge the latter by the difference between the breakeven inflation rate and agents’ inflation median expectations in the Focus Survey published by the Central Bank of Brazil. To proxy for inflation uncertainty, we employ the standard deviation of the 12-month inflation expectations in the Focus Survey. We first estimate the impact of inflation uncertainty on the inflation risk premia across different horizons using a VAR approach. We find that shocks in inflation uncertainty significantly affect the 9-, 12-, 24- and 36-month inflation risk premia. The impact is positive, increasing with maturity at least up to 12 months. We then estimate an alternative VAR specification that summarizes the term structure of inflarion risk premia by means of level, slope and curvature factors. It turns out that shocks in inflation uncertainty do not affect the slope and curvature factors, resulting only in parallel shifts in the inflation premium term structure. This is in line with the fact that the higher the inflation uncertainty, the higher is the compensation that investors will require to hold fixed rate bonds.

UK Term Structure Decompositions at the Zero Lower Bound

This paper employs a Zero Lower Bound (ZLB) consistent shadow-rate model to decompose UK nominal yields into expectation and term premia components. Compared to a standard affine term structure model, it performs relatively better in a ZLB setting and effectively captures the countercyclical nature of term premia. The ZLB model is then exploited to estimate inflation expectations and risk premia. This entails jointly pricing and decomposing nominal and real UK yields. We find evidence that medium- and long-term inflation expectations are contained within narrower bounds since the early 1990s, suggesting monetary policy credibility improved after the introduction of inflation targeting.

The Term Structure and Inflation Uncertainty

This paper develops and estimates a Quadratic-Gaussia model of the U.S. term structure that can accommodate the rich dynamics of inflation risk premia over the 1983-2013 period by allowing for time-varying market prices of inflation risk and incorporating survey information on inflation uncertainty in the estimation. The model captures changes in premia over very diverse periods, from the inflation scare episodes of the 1980s, when perceived inflation uncertainty was high, to the more recent episodes of negative premia, when perceived inflation uncertainty has been considerably smaller. A decomposition of the nominal ten-year yield suggests a decline in the estimated inflation risk premium of 1.7 percentage points from the early 1980s to mid-1990s. Subsequently, its predicted value has fluctuated around zero and turned negative at times, reaching its lowest values (about -0.6 percentage points) before the latest financial crisis, in 2005-2007, and during the subsequent weak recovery, in 2010-2012. The models ability to generate sensible estimates of the inflation risk premium has important implications for the other components of the nominal yield: expected real rates, expected inflation, and real risk premia.

Drivers of Inflation Compensation: Evidence from Inflation Swaps in Advanced Economies

In this note, we provide a comparative analysis of inflation swaps for three advanced economies: the United States, the euro area, and the United Kingdom. We consider empirical proxies for energy prices, economic activity, exchange rates, and risky asset prices as potential drivers of inflation expectations and risk premiums in a regression framework.

Forecast Uncertainty Surprises and Financial Markets

In this paper we study the impact of forecast uncertainty shocks on yields of nominal, inflation-indexed bonds and market-based inflation expectations during the period 1999-2011, in an event-study framework. To that end, we propose a new measure for forecast uncertainty surprises defined as the difference between root mean squared forecast errors (ex-post uncertainty) and forecast disagreement (ex-ante uncertainty). First, we document a significant relationship between uncertainty shocks about the forecasts of some economic fundamentals and financial markets. Second, we explore time variation in the response of asset markets to forecast uncertainty shocks across three macroeconomic regimes: a tranuil regime, a crisis regime and an unconventional monetary policy regime. Third, we conjecture that forecast uncertainty shocks impact asset prices through their effect on inflation and liquidity risk premia.

Has the Inflation Risk Premium Fallen? Is it Now Negative?

In this note, we examine the theoretical determinants of one important component of inflation compensation, the inflation risk premium, and argue that a secular decline in the inflation risk premium may be responsible for a substantial portion of the decline in inflation compensation in recent years.

Inflation targeting and interest rates: a panel time-series approach

Inflation Targeting (IT) can be expected to play a role in structurally reducing nominal interest rates by lowering a country’s inflation expectations and risk premium. Relying on a panel of 52 advanced and emerging economies from 1975–2009, we carry out a formal investigation of this hypothesis. Our econometric strategy adopts a flexible and efficient panel estimation framework, controlling for a number of issues usually neglected in the literature, such as parameter heterogeneity and cross-section dependence. The empirical analysis is based on a dynamic model. Our findings are supportive of a view that, on average, IT leads to a reduction of short- and long-term nominal interest rates.

Policy and Macro Signals as Inputs to Inflation Expectation Formation

How do private agents interpret central bank actions and communication? To what extent do the effects of monetary shocks depend on the information disclosed by the central bank? This paper investigates the effect of monetary shocks and shocks to the Bank of England’s inflation and output projections on the term structure of UK private inflation expectations, to shed light on private agents’ interpretation of central bank signals about policy and the macroeconomic outlook. We proceed in three steps. First, we correct our dependent variables - market-based inflation expectation measures - for potential risk, liquidity and inflation risk premia. Second, we extract exogenous shocks following Romer and Romer (2004)’s identification approach. Third, we estimate the linear and interacted effects of these shocks in an empirical framework derived from the information frictions literature. We find that private inflation expectations respond negatively to contractionary monetary policy shocks, consistent with the usual transmission mechanism. In contrast, we find that inflation expectations respond positively to positive central bank inflation or output projection shocks, suggesting private agents put more weight on the signal that they convey about future economic developments than about the policy outlook. However, when shocks to central bank inflation projections are interacted with shocks to output projections of the same sign, they have no effect on inflation expectations, suggesting that private agents understand the functioning of the central bank reaction function and put more weight on the policy signal when there is no trade-off. We also find that the effects of contractionary monetary shocks are amplified when they are accompanied by positive shocks to central bank inflation projections. The co-ordination of policy decisions and macroeconomic projections thus appears important for managing inflation expectations.