Disagreement about Inflation and the Yield Curve

Abstract:     
We study how differences in beliefs about expected inflation impact real and nominal yield curves in a frictionless economy. Inflation disagreement induces a spillover effect to the real side of the economy with a strong impact on the real yield curve. When investors have a coefficient of relative risk aversion greater than one, real yields across all maturities rise as disagreement increases. Real yield volatilities also rise with disagreement. Using the feature that nominal bond prices can be computed from weighted-averages of quadratic Gaussian yield curves, we explore three properties of the model numerically. First, both real and nominal yield curves are strongly impacted by inflation disagreement relative to a full information economy. Second, increased inflation disagreement drives nominal yields and nominal yield volatilities higher at all maturities. Third, expected inflation beliefs impact real yields. Empirical support for our predictions on yield levels and yield volatilities is provided.

Number of Pages in PDF File: 49

Keywords: Disagreement about expected inflation, feedback effect, real and nominal yields

JEL Classification: D51, E43, E52, G12

working papers series