PrefBlog

Mikhail Chernov & Philippe Mueller: The Term Structure of Inflation Expectations:

The ten-year inflation premium declines from six to zero per cent during the post-monetary-experiment period. This decline suggests that long-run inflation expectations became more stable over time. Further, we reestimate our model every quarter and find that the long-run expectations have declined over time from 6% to 2%. The inflation persistence declined and the term structure of inflation expectations became flat over time. This evidence suggests that monetary policy became better anchored.

One implication of anchored inflation expectations is that it should be easier to forecast inflation and yields. Consistent with this prediction, we find that the model that incorporates both yields nd surveys dominates in out-of-sample forecasting of both inflation and yields. These results lead us to conclude that information in surveys is extremely important for establishing the links between inflation expectations and yields.

Figure 4 shows the time-series of the inflation expectations at multiple horizons. These expectations are computed from AO. In contrast to the survey forecasts in Figure 1, these objective, or marginal, expectations can be computed each period at any horizon.

The term structure effects are pronounced. The inflation curve becomes inverted in 1973, right before the recession, and continues to be inverted until early 1982. This period coincides with the unstable period of monetary policy during the Burns and Miller chairmanship of the US Federal Bank and the monetary policy experiment under Volcker’s chairmanship. The curve became inverted again briefly in the early part of Greenspan’s tenure from 1987 to 1991. afterwards, it had a normal, nearly flat, shape.

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The out-of-sample analysis of the model suggests that monetary policy became more effective over time. The long-run expectations are anchored at about 2%. The term structure of inflation expectations has flattened out over time. This suggests that the arrival of new data does not affect long-run expectations much, perhaps because the monetary policy is expected to address all short term fluctuations successfully.

Christopher Reid, Frédéric Dion and Ian Christensen, Real Return Bonds: Monetary Policy Credibility and Short-Term Inflation Forecasting [broken link fixed 2023-1-21], Bank of Canada Review, Autumn 2004:

Chart 5 shows two proxies of long-run inflation uncertainty. The first is a measure of the disagreement among forecasters who responded to the Watson Wyatt survey, calculated as the difference between the upper and lower quartiles of reported inflation expectations at the 4- to 14-year horizon. The second measure is inflation uncertainty over a 5-year forecast horizon derived from a GARCH model developed by Crawford and Kasumovich (1996).

Côté et al. (1996) suggest that the increase in the BEIR [Break-Even Inflation Rate, Nominals less RRBs] in 1994, which was not accompanied by a similar move in survey measures, may reflect an increase in the inflation-risk premium. If changes in the premium for inflation uncertainty are an important factor in explaining movements in the BEIR, then sharp movements in these proxies should be associated with similar movements in the BEIR. Yet both measures fail to indicate a rise in inflation uncertainty in 1994 or a significant decline in 1997. Crawford and Kasumovich’s measure of inflation uncertainty fell dramatically during the 1980s but has been relatively stable since 1992. Similarly, survey disagreement fell between 1991 and 1994 but was relatively stable afterwards. The simplest explanation is that deviations of the BEIR from survey measures of inflation expectations are the result of some phenomenon other than changes in uncertainty regarding inflation.

Grishchenko, Olesya V. and Huang, Jing-Zhi, Inflation Risk Premium: Evidence from the TIPS Market (December 11, 2008).

“Inflation-indexed securities would appear to be the most direct source of information about in°ation expectations and real interest rates” (Bernanke, 2004). In this paper we study the term structure of real interest rates, expected in°ation and inflation risk premia using data on prices of Treasury Inflation Protected Securities (TIPS) over the period 2000-2007. The estimates of the 10-year inflation risk premium are between 11 and 22 basis points for 2000-2007 depending on the proxy used for the expected inflation. Furthermore, we find that the inflation risk premium is time varying and, specifically, negative in the first half (which might be due to either concerns of deflation or low liquidity of the TIPS market), but positive in the second half of the sample.
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This paper represents perhaps the first attempt to estimate the inflation risk premium directly using the prices of Treasury Inflation Protected Securities (TIPS). Using the market data on prices of TIPS over the period 2000-2007, we find that the 10-year average inflation risk premium ranges from 11 to 22 basis points. We also find that it is time-varying. More specifically, it is negative in 2000-2003 but positive in 2004-2007. The negative inflation risk premium during 2000-2003 is due to either concerns of deflation or liquidity problems in the TIPS market. There seems to be more evidence that supports the former explanation. The estimated average 10-year in°ation risk premium over the second half varies between 29 and 48 basis points, depending on the proxy used for the expected inflation. The estimates based on Blue Chips inflation forecast are the lowest (29 basis points), and the estimates based on one-year SPF are the highest (48 basis points). We also find that the inflation risk premium is considerably less volatile during 2004-2007, a finding consistent with the observations that in°ation expectations became more stable during this period, investors became more familiar with the TIPS market, and the market liquidity has gradually improved.

Our empirical results on in°ation risk premium estimated directly from TIPS should be valuable for practitioners, monetary authorities and policymakers alike because they help to assess the inflation expectations and the inflation risk premium of bond market investors.

The Inflation Risk Premium in the Term Structure of Interest Rates, Peter Hördahl, BIS Quarterly Review, September 2008:

A dynamic term structure model based on an explicit structural macroeconomic framework is used to estimate inflation risk premia in the United States and the euro area. On average over the past decade, inflation risk premia have been relatively small but positive. They have exhibited an increasing pattern with respect to maturity for the euro area and a flatter one for the United States. Furthermore, the estimates imply that risk premia vary over time, mainly in response to fluctuations in economic growth and inflation.
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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.

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I missed this when it came out.

The FDIC has released a rule increasing the complexity of deposit insurance premium calculations:

The final rule adds a new financial measure to the financial ratios method. This new financial measure, the adjusted brokered deposit ratio, will measure the extent to which brokered deposits are funding rapid asset growth. The adjusted brokered deposit ratio will affect only those established Risk Category I institutions whose total gross
assets are more than 40 percent greater than they were four years previously, after adjusting for mergers and acquisitions, rather than 20 percent greater as proposed in the NPR, and
whose brokered deposits (less reciprocal deposits) make up more than 10 percent of domestic deposits. Generally speaking, the greater an institution’s asset growth and the greater its percentage of brokered deposits, the greater will be the increase in its initial base assessment rate. Small changes in asset growth rate or brokered deposits as a percentage of domestic deposits will lead to small changes in assessment rates.

The Canadian approach is not nearly so nuanced since our bankers are ever so smart. In fact, they’re all equally smart, with the vast majority of assets in the system paying into the CDIC fund at the same rate, which is considered desirable. Not so in the States:

A commenting bank argued that:

Arbitrarily establishing targets for percentages of institutions that fall into a given assessment rate is inconsistent with not only the governing statute but the whole concept of risk-based pricing….

The FDIC disagrees with the commenting bank. The purpose of the new large bank method is to create an assessment system for large Risk Category I institutions that will respond more timely to changing risk profiles, will improve the accuracy of initial assessment rates, relative risk rankings, and will create a greater parity between small and large Risk Category I institutions.

Imagine that! Rewards for being better than the competition, even if only by a little bit! It’s a good thing we don’t have that sort of nonsense in Canada – it can lead to bonuses.

Since the FDIC is not Canadian, they address criticism, allowing investors and observers to take an informed view of the desirability of changes:

The FDIC received many comments arguing that brokered deposits should not increase assessment rates for Risk Category I institutions and that the brokered deposit provisions in the NPR do not account for the use to which institutions put these deposits. The FDIC is not persuaded by the arguments. Recent data show that institutions with a combination of brokered deposit reliance and robust asset growth tend to have a greater concentration in higher risk assets. In addition, there is a statistically significant correlation between the adjusted brokered deposit ratio, on the one hand, and the probability that an institution will be downgraded to a CAMELS rating of 3, 4, or 5 within a year, on the other, independent of the other measures of asset quality contained in the financial ratios method.