Extracting inflation expectations and inflation risk premia from the term structure: a joint model of the UK nominal and real yield curves

Michael Joyce (), Peter Lildholdt () and Steffen Sorensen ()
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Michael Joyce: Bank of England, Postal: Threadneedle Street London EC2R 8AH

No 360, Bank of England working papers from Bank of England

Abstract: This paper analyses the nominal and real interest rate term structures in the United Kingdom over the fifteen-year period that the UK monetary authorities have pursued an explicit inflation target, using a four-factor essentially affine term structure model. The model imposes no-arbitrage restrictions across nominal and real yields, enabling us to decompose nominal forward rates into expected real short rates, expected inflation, real term premia and inflation risk premia. We find that inflation risk premia and longer-term inflation expectations fell significantly when the Bank of England was made operationally independent in 1997. The 'conundrum' of unusually low long-term real rates that began in 2004 is mainly attributed by the model to a fall in real term premia, though a significant part of the fall is left unexplained. The relative inability of the model to fit long real forwards during much of this recent period may reflect strong pension fund demand for index-linked bonds. Moreover, the model decompositions suggest that these special factors affecting the index-linked market may also partly account for the contemporaneous rise in longer-horizon inflation breakeven rates.

Keywords: Inflation expectations; inflation risk premia; affine term structure model (search for similar items in EconPapers)
JEL-codes: C40 E43 E52 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
Date: 2009-02-16

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Persistent link: http://EconPapers.repec.org/RePEc:boe:boeewp:0360

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