PrefBlog

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.

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