Inflation Risk and the Inflation Risk Premium

Abstract

This article starts by discussing the concept of “inflation hedging” and provides some estimates of “inflation betas” for standard bond and well-diversified equity indices for over 45 countries. We show that such standard securities are poor inflation hedges. Expanding the menu of assets to foreign bonds, real estate and gold only improves matters marginally. This indicates a potentially important role for inflation index linked bonds. We then briefly discuss the pros and cons of such bonds, focusing the discussion mostly on the situation in the US, which started to issue Treasury Inflation Protected Securities (TIPS in short) in 1997. We argue that it is hard to negate the benefits of such securities for all relevant parties, unless the market in which they trade is highly deficient, which was actually the case in its early years in the US. Finally, we describe how state-of-the-art term structure research has tried to uncover estimates of the inflation risk premium. Most studies, including very recent ones that actually use inflation-linked bonds and information in surveys to gauge inflation expectations, find the inflation risk premium to be sizable and to substantially vary through time. This implies that governments should normally lower their financing costs through the issuance of index-linked bonds, at least in an ex-ante sense.

Keywords: Inflation risk, risk premium, hedge, inflation protected bond, term structure model

JEL Classification: E44, G12, G15