The Information Content of the Inflation Term Structure

Abstract

This paper examines the information content of inflation forecasts derived using index-linked and conventional bonds. The paper finds that the derived inflation term structure (ITS) gives a somewhat better indication of the bond market's inflation expectation than can be derived using either the nominal term structure or a variant employing strong assumptions about real interest rate behavior. The inflation forecasts of the ITS also seem at least as good at forecasting future changes in inflation as forecasts derived from macroeconometric models.

These characteristics of the ITS and its timeliness tend to make its inflation forecasts a useful addition to policy analysis. Because the real term structure tends to underpredict the level of future real interest rates, index-linked bonds have proved, ex post, to be cheap funding for the U.K. government. But we cannot be sure whether this underprediction results from an inflation risk premium or expectational error and also cannot know whether this overprediction will persist.

JEL Classification: E31, E43, G12, G14