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May 30, 2020 What does the bond market tell us about inflation risk? Answer to the quiz: We overlooked the fact that inflation is uncertain. Interest rates on the nominal bond and the inflation-indexed bond imply that investors are indifferent between earning minus 0.1% and earning 0.7% plus inflation. If inflation was known for sure, we could safely conclude that inflation will be 0.6% for sure. But inflation is uncertain, so a payment indexed on inflation commands a risk premium. The expected return on the inflation-indexed bond need not be equal to that on the nominal bond. Suppose for instance that high inflation is associated with worse economic outcomes. The inflation-indexed bond is therefore a good hedge because it provides you with a higher return in bad states. We are therefore willing to pay more, or equivalently to earn a lower expected return, on the inflation-indexed bond. For instance, the 0.6% gap between the nominal bond and the inflation-indexed bond can be consistent with 0.3% expected inflation and a 0.3% inflation risk premium. Conversely, if deflation is associated with worse economic outcomes, the logic is flipped on its head and the inflation risk premium is negative. In this case, expected inflation is higher than 0.6% per year. It is usually considered that the inflation risk premium adjustment is small (not necessarily with strong arguments, though). So in practice, we simply use the difference between the yields on the nominal bond and inflation-indexed bond to infer expected inflation and we abstract from the inflation risk premium. |