Deriving inflation forecasts from government bond prices

Abstract

In financial research and practice, it is widely accepted that nominal interest rates derived from the prices of various financial products of different maturities comprise of corresponding real interest rates and inflation. While extensive research has been conducted on the relationship between these three variables, estimation of their levels is still largely based on the industry surveys and market data. As this information only indicates the current expectations of interest rate and inflation movements over time, a number of caveats should be noted when interpreting such measures. In the US and the UK, where the government bond markets are the largest and most active, a comparative analysis between conventional government bonds and those whose yield is linked to inflation provides a measure of inflation expectations. However, as such analyses implicitly assume that investment in government bonds is virtually risk free, it is questionable whether the derived estimates are of any value in current economic conditions. Moreover, this approach cannot be generalized to other countries, where number of traded products from which any relationship between interest rates and inflation can be determined is limited and different economic conditions prevail. Thus, this paper aims to present an overview of the methodologies used to forecast inflation rates from government bond prices, drawing attention to the key assumptions and limitations of these approaches. The goal is to ascertain their accuracy, and thus their value in determining the real yields of various interest rate-linked products.

Keywords

• government bond yields
• Fisher equation
• CPI
• inflation
• index-linked gilts