The inflation risk premium and the macroeconomy
In order to gain some insight into what the underlying drivers of inflation risk
premia are, it is useful to investigate how they evolve in response to changes in
the macroeconomic state variables. Ultimately, all time variation in the
estimated premia will be due to movements in these variables. It turns out that
two of the state variables are the main drivers of inflation premia in the United
17
The same result holds for five-year forward break-even rates five years ahead, a common
indicator of market inflation expectations for distant horizons. For the United States, the
premium-adjusted version of this forward break-even rate has differed little from the raw
version, while in the case of the euro area the adjustment has generally resulted in a
significantly lower level compared to the raw series (see BIS (2008, pp 112–13)).
… are close to
survey inflation
expectations
BIS Quarterly Review, September 2008
35
States as well as in the euro area: the output gap and inflation. Broad
movements in the 10-year inflation risk premium largely match those of the
output gap, while higher-frequency fluctuations in the premium seem to be
aligned with changes in the level of inflation.
Movements in the output gap and in inflation are due to combinations of
the structural shocks in the model, so, to better understand the ultimate
determinants of premia, it is necessary to examine their reaction to such
shocks. One of the advantages of the modelling strategy adopted here is that it
makes it possible to compute impulse response functions of yields and
associated premia to the underlying macro shocks. Graphs 5 and 6 show US
and euro area responses of inflation risk premia and expected inflation to
demand and supply shocks. The left-hand panels refer to a two-year horizon
and the right-hand panels to a 10-year horizon. These graphs show that the
responses of inflation premia to demand shocks (ie shocks to the output gap in
equation (3)) are much more persistent than responses to supply shocks
(ie shocks to inflation in equation (4)). Intuitively, this reflects the fact that the
effects on inflation and output from demand shocks are substantially longer-
lasting than those from supply shocks.
Looking at the results in more detail, a positive shock to US aggregate
demand, corresponding to a 1 percentage point increase in the shock to the
output gap in equation (3), pushes up the 10-year inflation premium by around
13 basis points (Graph 5, right-hand panel), possibly reflecting perceptions of a
higher risk of upside inflation surprises as the output gap widens. A positive
demand shock also raises the average expected inflation rate by about 7 basis
points, resulting in an overall increase in the 10-year break-even rate (ie the
sum of the two responses) of some 20 basis points. At the two-year horizon
(Graph 5, left-hand panel), the effect on the break-even rate from a demand
shock is even larger, at around 35 basis points on impact, but now the bulk of
the response is due to rising inflation expectations, while the inflation premium
US impulse responses
In per cent
Two-year responses
Ten-year responses
–0.1
0
0.1
0.2
0.3
0
10
20
30
40
50
60
Inflation risk premium response
to demand shock
Expected inflation response
to demand shock
–0.04
0
0.04
0.08
0.12
0
10
20
30
40
50
60
Inflation risk premium
response to supply shock
Expected inflation
response to supply shock
The demand shock corresponds to a 1 percentage point increase in the shock to the output gap in
equation (3), while the supply shock is a 1 percentage point increase (in annualised terms) in the shock to
inflation in equation (4). Horizontal axis measures the horizon of the responses in months.
Source: Author’s calculations.
Graph 5
… with demand
shocks having
persistent effects …
Inflation and output
movements drive
developments in
inflation premia …
36
BIS Quarterly Review, September 2008
response is similar to the 10-year case. Demand shocks therefore seem to
induce parallel shifts in the inflation premium, while inflation expectations react
much more strongly for short maturities than for long.
The responses to supply shocks in Graph 5 (corresponding to a
1 percentage point increase in the shock to inflation in equation (4)) are clearly
less pronounced and less persistent than for demand shocks. Nonetheless, the
short-term reaction of both expected inflation and inflation risk premia at the
two-year horizon is sizeable. This suggests that investors become more averse
to inflation risk as inflation rises.
As in the United States, a positive demand shock also raises expected
inflation in the euro area, and more so at the two-year horizon than at the
10-year horizon (Graph 6). However, in contrast to the US case, the inflation
premium response is uniformly negative, albeit small. In terms of the response
of euro area break-even inflation to demand shocks, the two effects largely
cancel out. Given that the inflation risk premium accounts for a sizeable portion
of the overall term premium, this negative response of the inflation premium to
demand shocks appears to be in line with evidence from Germany prior to the
introduction of the euro, as documented in Hördahl et al (2006), where term
premia reacted negatively to positive demand shocks. A possible explanation
for this finding could be that investors become more willing to take on risks –
including inflation risks – during booms, while they require larger premia during
recessions.
18
With respect to euro area responses to a supply shock, the results in
Graph 6 are qualitatively similar to those for the United States. A 1 percentage
point upward shock to aggregate supply raises the two-year break-even rate by
around 40 basis points on impact, an effect that quickly wears off. Most of this
18
Such effects have been found elsewhere. Piazzesi and Swanson (2008), for example, report
strongly countercyclical risk premia based on estimates on federal funds futures prices.
Euro area impulse responses
In per cent
Two-year responses
Ten-year responses
–0.1
0
0.1
0.2
0.3
0
10
20
30
40
50
60
Inflation risk premium response
to demand shock
Expected inflation response
to demand shock
–0.04
0
0.04
0.08
0.12
0
10
20
30
40
50
60
Inflation risk premium response
to supply shock
Expected inflation response
to supply shock
The demand shock corresponds to a 1 percentage point increase in the shock to the output gap in
equation (3), while the supply shock is a 1 percentage point increase (in annualised terms) in the shock to
inflation in equation (4). Horizontal axis measures the horizon of the responses in months.
Source: Author’s calculations.
Graph 6
… while the impact
of supply shocks is
short-lived
BIS Quarterly Review, September 2008
37
increase is due to a higher two-year inflation premium (over 30 basis points). At
the 10-year horizon, the break-even response is similarly short-lived and
substantially smaller at around 10 basis points, predominantly due to the
inflation premium.
Conclusion
This article estimates inflation risk premia using a dynamic term structure
model based on an explicit structural macroeconomic model. The identification
and quantification of such premia are important because they introduce a
wedge between break-even inflation rates and investors’ expectations of future
inflation. In addition, inflation risk premia per se may provide useful information
to policymakers with respect to market participants’ aversion to inflation risks
as well as to their perceptions about such risks.
The results show that inflation risk premia in the United States and in the
euro area are on average positive, but relatively small. Moreover, the estimated
premia vary over time, mainly in response to changes in economic activity, as
measured by the output gap, and inflation. The estimates suggest that
fluctuations in output drive much of the cyclical variation in inflation premia,
while high-frequency premia fluctuations are mostly due to changes in the level
of inflation.
References
Ang, A, G Bekaert and M Wei (2008): “The term structure of real rates and
expected inflation”,
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