Working Paper: CEPR ID: DP2022
Authors: Eli M. Remolona; Michael R. Wickens; Frank F. Gong
Abstract: A measure of the credibility of monetary policy is the inflation risk premium embodied in nominal yields. This will be time varying and can be estimated by combining the information contained in the nominal term structure of interest rates with that in the real term structure of inflation-indexed bonds. Information can also be obtained about the real risk premium, and about expected inflation. We estimate these risk premia using a generalization of the Cox-Ingersoll-Ross (CIR) affine-yield model. We use a one-factor model of the real term structure based on monthly observations on two-year, five-year and ten-year UK index-linked debt, and a two-factor model of the nominal term structure for the corresponding nominal yields. Our estimates show that the inflation risk premium contributes on average about 100 basis points to nominal yields. Since the exit from the Exchange Rate Mechanism (ERM) this has fallen to about 70 basis points. This shows the greater credibility of monetary policy in recent years. The real risk premium is much higher, and has fluctuated between 170 and 260 basis points since exit from the ERM, reflecting uncertainty about the real economy. The inflation risk premium provides a correction to the break-even method of forecasting inflation and produces an unbiased forecast.
Keywords: inflation risk; expected inflation; indexed bonds; affine yields; monetary policy
JEL Codes: E31; E43; E62; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| inflation risk premium (E31) | nominal yields (G12) |
| exit from ERM (Y60) | inflation risk premium (E31) |
| credibility of monetary policy (E52) | inflation risk premium (E31) |
| inflation risk premium (E31) | unbiased forecast of inflation (E31) |
| nominal yield curve's slope (E43) | expected future direction of inflation (E31) |
| exit from ERM (Y60) | credibility of monetary policy (E52) |
| inflation risk premium (E31) | correction to break-even method (C51) |