Inflation Expectations and Risk Premiums in an Arbitrage‐Free Model of Nominal and Real Bond Yields

Abstract

Differences between yields on comparable-maturity U.S. Treasury nominal and real debt, the so-called breakeven inflation (BEI) rates, are widely used indicators of inflation expectations. However, better measures of inflation expectations could be obtained by subtracting inflation risk premiums from the BEI rates. We provide such decompositions using an estimated affine arbitrage-free model of the term structure that captures the pricing of both nominal and real Treasury securities. Our empirical results suggest that long-term inflation expectations have been well anchored over the past few years, and inflation risk premiums, although volatile, have been close to zero on average. † We thank participants at the FRB/JMCB conference for helpful comments, especially our discussant Stanley Zin, as well as the editors and referees. The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Federal

Inflation Expectations and the News

“…The ultimate goal of this paper is to learn about the importance of inflation expectations, the second term in equation (2), for variation in long-term nominal rates. To obtain evidence about inflation expectations based on an analysis using inflation compensation, one needs to either resort to a model for estimating the risk premium, as in D' Amico et al (2010) or Christensen et al (2010), or make additional assumptions about the behavior of this risk premium. Because estimates of the inflation risk premium are highly uncertain and model-dependent, I focus on documenting patterns in inflation compensation and do not attempt to correct for a risk premium.…”

Identification and estimation of Gaussian affine term structure models

“…Its appeal comes from its simple characterization of how risk gets priced by the market which, under the assumption of no arbitrage, generates predictions for the price of any asset. The approach has been used to measure the role of risk premia in interest rates (Duffee, 2002;Cochrane and Piazzesi, 2009), study how macroeconomic developments and monetary policy affect the term structure of interest rates (Ang and Piazzesi, 2003;Beechey and Wright, 2009;Bauer, 2011), characterize the monetary policy rule (Ang, Dong, and Piazzesi, 2007;Rudebusch and Wu, 2008;Bekaert, Cho, and Moreno, 2010), determine why long-term yields remained remarkably low in 2004 and 2005 (Kim and Wright, 2005;Rudebusch, Swanson, and Wu, 2006), infer market expectations of inflation from the spread between nominal and inflation-indexed Treasury yields (Christensen, Lopez, and Rudebusch, 2010), evaluate the effectiveness of the extraordinary central bank interventions during the financial crisis (Christensen, Lopez, and Rudebusch, 2009;Smith, 2010), and study the potential for monetary policy to affect interest rates when the short rate is at the zero lower bound Hamilton and Wu (forthcominga).…”

Interest Rates Under Falling Stars

“…First, our approach is arguably conservative, because our macro trend estimates have not been fine-tuned to incorporate the information in long-term yields via no-arbitrage restrictions. We avoid using trend estimates from the literature that are derived from long-term yields, such as the estimates of π * t by Christensen et al (2010) or estimates of r * t by Johannsen and Mertens (2016), Rudebusch (2017), or Del Negro et al (2017). It would be somewhat tautological to demonstrate a link between long-term bond yields and a trend that was estimated from those yields.…”