Extracting Inflation Expectations and Inflation Risk Premia from the Term Structure: A Joint Model of the UK Nominal and Real Yield Curves

48 Pages Posted: 17 Feb 2009

See all articles by Michael Joyce

Michael Joyce

Bank of England - Monetary Analysis

Peter M. Lildholdt

Bank of England - Monetary Analysis

Steffen Sorensen

Moody's Investor Services

Date Written: February 16, 2009

Abstract

This paper analyses the nominal and real interest rate term structures in the United Kingdom over the fifteen-year period that the UK monetary authorities have pursued an explicit inflation target, using a four-factor essentially affine term structure model. The model imposes no-arbitrage restrictions across nominal and real yields, enabling us to decompose nominal forward rates into expected real short rates, expected inflation, real term premia and inflation risk premia. We find that inflation risk premia and longer-term inflation expectations fell significantly when the Bank of England was made operationally independent in 1997. The 'conundrum' of unusually low long-term real rates that began in 2004 is mainly attributed by the model to a fall in real term premia, though a significant part of the fall is left unexplained. The relative inability of the model to fit long real forwards during much of this recent period may reflect strong pension fund demand for index-linked bonds. Moreover, the model decompositions suggest that these special factors affecting the index-linked market may also partly account for the contemporaneous rise in longer-horizon inflation breakeven rates.

Keywords: Inflation expectations, inflation risk premia, affine term structure model

JEL Classification: C40, E43, E52

Suggested Citation

Joyce, Michael and Lildholdt, Peter M. and Sorensen, Steffen, Extracting Inflation Expectations and Inflation Risk Premia from the Term Structure: A Joint Model of the UK Nominal and Real Yield Curves (February 16, 2009). Bank of England Working Paper No. 360. Available at SSRN: https://ssrn.com/abstract=1344283 or http://dx.doi.org/10.2139/ssrn.1344283

Michael Joyce (Contact Author)

Bank of England - Monetary Analysis ( email )

Threadneedle Street
London EC2R 8AH
United Kingdom
44 (0)207 601 4444 (Phone)

HOME PAGE: http://www.bankofengland.co.uk

Peter M. Lildholdt

Bank of England - Monetary Analysis ( email )

Threadneedle Street
London EC2R 8AH
United Kingdom

Steffen Sorensen

Moody's Investor Services

New York, NY 10007
United States

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