New tips from TIPS: Identifying inflation expectations and the risk premia of break-even inflation
The Quarterly Review of Economics and Finance, 2013, vol. 53, issue 2, 125-139
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.
Keywords: Treasury inflation protected security; Break-even inflation; Inflation expectation; Risk premium; Common factor model; ARCH (search for similar items in EconPapers)
JEL-codes: G12 C32 E43 E31 (search for similar items in EconPapers)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:quaeco:v:53:y:2013:i:2:p:125-139
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