The informational content of market-based measures of inflation expectations derived from govenment bonds and inflation swaps in the United Kingdom

Zhuoshi Liu, Elisabetta Vangelista (), Iryna Kaminska and Jon Relleen ()
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Elisabetta Vangelista: UK Debt Management Office, Postal: Publications Group Bank of England Threadneedle Street London EC2R 8AH
Jon Relleen: Bank of England, Postal: Publications Group Bank of England Threadneedle Street London EC2R 8AH

No 551, Bank of England working papers from Bank of England

Abstract: Market-based measures of inflation expectations can be derived either from the difference between yields on nominal and inflation-linked government bonds or from inflation swap rates. These measures are important indicators of the outlook for inflation and are monitored regularly by the United Kingdom’s Monetary Policy Committee (MPC), alongside other measures of inflation expectations such as those based on surveys. However, the market rates we observe are not perfect measures of expected future inflation. Moreover, in the United Kingdom inflation-linked market instruments reference RPI inflation, whereas the MPC’s target is CPI inflation of 2%. To better extract useful information about expectations for CPI inflation, we develop a no-arbitrage term structure model to decompose the forward inflation curve into: measures of CPI inflation expectations; the expected spread between expected RPI and CPI inflation (the RPI/CPI inflation ‘wedge’); and estimates of risk premia. We then further decompose risk premia estimates into inflation risk premia and liquidity risk premia. We show that long-horizon expectations of CPI inflation, as implied by our model, fell in the 1990s after the introduction of inflation targeting and the creation of the MPC and have since remained fairly stable at around 2%. Our model also suggests that the large falls in measures of implied inflation based on index-linked gilts after the financial crisis were to a large extent the result of changes in liquidity premia in inflation-linked gilt prices.

Keywords: Affine arbitrage-free dynamic term structure model; breakeven inflation; inflation expectations; risk premia; funding liquidity; survey expectations (search for similar items in EconPapers)
JEL-codes: C40 E31 E43 E52 G12 (search for similar items in EconPapers)
Pages: 36 pages
Date: 2015-09-25
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
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Citations: View citations in EconPapers (3)

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