Inflation Expectations and Risk Premiums in an Arbitrage-Free Model of Nominal and Real Bond Yields


  • We thank participants at the FRB/JMCB conference for helpful comments, especially our discussant Stanley Zin, as well as the editors and referees. The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Federal Reserve Bank of San Francisco or the Board of Governors of the Federal Reserve System.


Differences between yields on comparable-maturity U.S. Treasury nominal and real debt, the so-called breakeven inflation (BEI) rates, are widely used indicators of inflation expectations. However, better measures of inflation expectations could be obtained by subtracting inflation risk premiums (IRP) from the BEI rates. We provide such decompositions using an affine arbitrage-free model of the term structure that captures the pricing of both nominal and real Treasury securities. Our empirical results suggest that long-term inflation expectations have been well anchored over the past few years, and IRP, although volatile, have been close to zero on average.