The market for inflation risk

Saleem Bahaj, Robert Czech, Sitong Ding () and Ricardo Reis
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Sitong Ding: London School of Economics

No 1028, Bank of England working papers from Bank of England

Abstract: This paper uses transaction-level data on the universe of traded UK inflation swaps to characterise who buys and sells inflation risk, when, and with what price elasticity. This provides measures of expected inflation cleaned from liquidity frictions. We first show that this market is segmented: pension funds trade at long horizons while hedge funds trade at short horizons, with dealer banks as their counterparties in both markets. This segmentation suggests three identification strategies – sign restrictions, granular instrumental variables, and heteroskedasticity – for the demand and supply functions of each investor type. Across the three strategies, we find that (i) prices absorb new information within three days; (ii) the supply of long-horizon inflation protection is very elastic; and (iii) short-horizon price movements are unreliable measures of expected inflation as they primarily reflect liquidity shocks. Our counterfactual measure of long-horizon expected inflation in the absence of these shocks suggests that the risk of a deflation trap during the pandemic and of a persistent rise in inflation following the energy shocks were overstated, while since Autumn of 2022, expected inflation has been lower and falling more rapidly than conventional measures.

Keywords: Asset demand system; monetary policy; anchored expectations; identification of demand and supply shocks. (search for similar items in EconPapers)
JEL-codes: C30 E31 E44 G12 (search for similar items in EconPapers)
Pages: 67 pages
Date: 2023-06-23
New Economics Papers: this item is included in nep-cba, nep-mon and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:boe:boeewp:1028

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