Disagreement About Inflation and the Yield Curve

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