Extracting inflation expectations and risk premia from the breakeven inflation rate in Iceland

Thórarinn Pétursson

Economics from Department of Economics, Central bank of Iceland

Abstract: The yield spread between a conventional nominal bond and a corresponding inflation-indexed bond – the so-called breakeven inflation rate – is a common measure of investors’ inflation expectations. But the spread also includes two risk premia that can distort the breakeven rate as a measure of inflation expectations. I use a signal-extraction approach is used to jointly estimate underlying inflation expectations and the inflation and liquidity risk premia from Icelandic data on 2-year breakeven inflation rates. The estimated 2-year inflation expectations are much smoother than the breakeven rate and remain above the official 2.5% inflation target for most of the sample period. The two risk premia are found to be large and time-varying, highlighting the need for caution when interpreting the breakeven rate as a direct measure of inflation expectations. Finally, I find that the three subcomponents of the breakeven rate react differently to an unanticipated monetary tightening. The tightening leads to a gradual and persistent decline in inflation expectations and the inflation risk premium partly offset by a temporary increase in the liquidity premium, consistent with the “risk-taking” channel of monetary policy.

JEL-codes: C32 E31 E43 E44 G12 (search for similar items in EconPapers)
Date: 2024-10
New Economics Papers: this item is included in nep-ban, nep-cba and nep-mon
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