Disagreement About Inflation and the Yield Curve

Posted: 22 Nov 2015

See all articles by Paul Ehling

Paul Ehling

BI - Norwegian Business School

Michael F. Gallmeyer

University of Virginia (UVA) - McIntire School of Commerce

Christian Heyerdahl-Larsen

Indiana University - Kelley School of Business - Department of Finance

Philipp K. Illeditsch

University of Pennsylvania - Finance Department

Multiple version iconThere are 2 versions of this paper

Date Written: November 19, 2015

Abstract

We show theoretically that inflation disagreement drives a wedge between real and nominal yields and raises their levels and volatilities. We demonstrate empirically that an inflation disagreement increase of one standard deviation raises real and nominal yields and their volatilities, break-even inflation, and the inflation risk premium by at least 30% of their respective standard deviations. Inflation disagreement is positively related to consumers’ cross-sectional consumption growth volatility and trading in bonds, interest rate futures, and inflation swaps. Calibrating the model to disagreement, inflation, and yield data reproduces the economically significant impact of inflation disagreement on real and nominal yield curves.

Keywords: inflation disagreement, relative entropy, real and nominal yields, yield volatilities, break-even inflation, inflation risk premium, cross-sectional consumption growth volatility, trading on inflation

JEL Classification: D51, E43, E52, G12

Suggested Citation

Ehling, Paul and Gallmeyer, Michael F. and Heyerdahl-Larsen, Christian and Illeditsch, Philipp K., Disagreement About Inflation and the Yield Curve (November 19, 2015). Banco de Espana Working Paper No. 1532. Available at SSRN: https://ssrn.com/abstract=2693147 or http://dx.doi.org/10.2139/ssrn.2693147

Paul Ehling (Contact Author)

BI - Norwegian Business School ( email )

N-0442 Oslo
Norway
+47 46410505 (Phone)

Michael F. Gallmeyer

University of Virginia (UVA) - McIntire School of Commerce ( email )

P.O. Box 400173
Charlottesville, VA 22904-4173
United States
434-243-4043 (Phone)
434-924-7074 (Fax)

HOME PAGE: http://www.commerce.virginia.edu/faculty_research/facultydirectory/Pages/Gallmeyer.aspx

Christian Heyerdahl-Larsen

Indiana University - Kelley School of Business - Department of Finance ( email )

1309 E. 10th St.
Bloomington, IN 47405
United States

Philipp K. Illeditsch

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States
215-898-3477 (Phone)

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