What was the Market's View of UK Monetary Policy? Estimating Inflation Risk and Expected Inflation with Indexed Bonds

Mike Jacobs, Eli Remolona and Michael Wickens

No 2022, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: A measure of the credibility of monetary policy is the inflation risk premium embodied in nominal yields. This will be time varying and can be estimated by combining the information contained in the nominal term structure of interest rates with that in the real term structure of inflation-indexed bonds. Information can also be obtained about the real risk premium, and about expected inflation. We estimate these risk premia using a generalization of the Cox-Ingersoll-Ross (CIR) affine-yield model. We use a one-factor model of the real term structure based on monthly observations on two-year, five-year and ten-year UK index-linked debt, and a two-factor model of the nominal term structure for the corresponding nominal yields. Our estimates show that the inflation risk premium contributes on average about 100 basis points to nominal yields. Since the exit from the Exchange Rate Mechanism (ERM) this has fallen to about 70 basis points. This shows the greater credibility of monetary policy in recent years. The real risk premium is much higher, and has fluctuated between 170 and 260 basis points since exit from the ERM, reflecting uncertainty about the real economy. The inflation risk premium provides a correction to the break-even method of forecasting inflation and produces an unbiased forecast.

Keywords: affine yields; expected inflation; indexed bonds; inflation risk; Monetary Policy (search for similar items in EconPapers)
JEL-codes: E31 E43 E62 G12 (search for similar items in EconPapers)
Date: 1998-11
References: Add references at CitEc
Citations: View citations in EconPapers (16)

Downloads: (external link)
http://www.cepr.org/active/publications/discussion_papers/dp.php?dpno=2022 (application/pdf)
CEPR Discussion Papers are free to download for our researchers, subscribers and members. If you fall into one of these categories but have trouble downloading our papers, please contact us at subscribers@cepr.org

Related works:
Working Paper: What was the market's view of U.K. monetary policy? Estimating inflation risk and expected inflation with indexed bonds (1998)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:cpr:ceprdp:2022

Ordering information: This working paper can be ordered from
http://www.cepr.org/ ... ers/dp.php?dpno=2022

Access Statistics for this paper

More papers in CEPR Discussion Papers from C.E.P.R. Discussion Papers Centre for Economic Policy Research, 33 Great Sutton Street, London EC1V 0DX.
Bibliographic data for series maintained by ().