INFLATION RISK PREMIA IN THE TERM STRUCTURE OF INTEREST RATES

Authors


  • The editor in charge of this paper was Fabio Canova.

  • Acknowledgments: The opinions expressed are personal and should not be attributed to the Bank for International Settlements or the European Central Bank. We wish to thank two anonymous referees, Claudio Borio, Andrea Buraschi, Fabio Canova, Mike Chernov, Jordi Galí, Don Kim, Frank Packer, Adrien Verdelhan, and seminar participants at the Hong Kong Monetary Authority, the 2005 ECB-BIS workshop on “Macro-finance modelling of the term structure of interest rates”, the CEF 2006, the EEA 2006, the 2007 Dallas Fed /Cleveland Fed Conference on “Price Measurement for Monetary Policy”, the 2007 Far Eastern Meeting of the Econometric Society, and the 2007 ECB workshop on “Modelling Inflation Risk Premia in Bond Markets” for useful comments and suggestions. We are especially grateful to David Vestin for extensive discussions of an early version.

E-mail addresses: peter.hoerdahl@bis.org (Hördahl) oreste.tristani@ecb.int (Tristani)

Abstract

This paper estimates the size and dynamics of inflation risk premia in the euro area, based on a joint model of macroeconomic and term structure dynamics. Information from both nominal and index-linked yields is used in the empirical analysis. Our results indicate that the inflation risk premium on euro area 10-year nominal yields was approximately equal to 20 basis points on average over the 1999–2007 period. The inflation premium has also been subject to moderate, but statistically significant fluctuations. For the post-2003 period in which reliable index-linked bond prices are available, our results suggest that increases in the raw break-even inflation rate above 2%, the upper bound of the European Central Bank's definition for price stability, have mostly reflected variations in the inflation risk premium, while long-term inflation expectations have remained well anchored.

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