Inflation Compensation and Monetary Policy

Abstract

We examine the transmission mechanism of monetary policy to inflation markets. We decompose monetary policy shocks in the United States into two orthogonal channels: the policy channel, measured by the change in 2-year nominal Treasury yield, and the communication channel, measured by the orthogonal change in 10-year nominal Treasury yield. We find that the conventional monetary policy affects long-term market-based inflation compensation through the communication channel, while the unconventional monetary policy affects short-term market-based inflation compensation through the policy channel. Our analysis also indicates that an announcement of quantitative easing corrects the short-term mispricing between the two inflation compensation measures, but amplifies long-term mispricing.

Keywords: monetary policy, inflation compensation, zero bound, quantitative easing, term structure

JEL Classification: E31, E43, E52, G12