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Unformatted text preview: Do inflation-linked bonds contain information about future inflation? * Jos e Valentim Machado Vicente Osmani Teixeira de Carvalho Guillen Abstract There is a widespread belief that inflation-linked bonds are a di- rect source of information about inflation expectations. In this paper we address this issue by analyzing the relationship between break- even inflation (the difference between nominal and real yields) and future inflation. The dataset is extracted from Brazilian Treasury bonds covering the period from April 2005 to July 2010. We find that break-even inflation is an unbiased forecast only of the 3-month and 6-month ahead inflation. For medium horizons (12 and 18 months) break-even inflation has weak explanatory power of future inflation. Over long horizons (24 and 30 months), we report a significant, but counterintuitive, negative relationship between the break-even and re- alized inflations. Keywords: inflation-linked bonds; real and nominal yields; term pre- mia; break-even inflation JEL Code: E31, E43, G12 . * The views expressed are those of the authors and do not necessarily reflect the views of the Central Bank of Brazil. Jos e Valentim M. Vicente gratefully acknowledges financial support from CNPQ Foundation. Banco Central do Brasil. E-mail: email@example.com. Banco Central do Brasil. E-mail: firstname.lastname@example.org. 1 1 Introduction Market participants and policymakers interpret break-even inflation (the spread between nominal and real yields) as the main indicator of expected inflation. According to the Federal Reserve chairman, inflation-linked bonds appear to be the most important source of future inflation expectations (Bernanke, 2004). However, it is well known that the break-even inflation rate (BEIR) can be decomposed as an inflation expectation plus a risk pre- mium term. This leads to the following questions: Does the BEIR efficiently predict future inflation? In other words, is the inflation risk premium neg- ligible? A more general formulation of these issues can be stated as: Do inflation-linked bonds contain information about future prices? In this pa- per we shed light on these questions through a model free procedure using data on Brazilian Treasury yields. Our analysis is based on a series of regressions between the realized in- flation (dependent variable) and the BEIR (independent variable) for the horizons of 3, 6, 12, 18, 24 and 30 months. The significance of the param- eters and R 2 provide a way to test the predictive ability and explanatory power of the BEIR. To avoid specification problems such as autocorrelations and endogeneity, we run these regressions using different approaches. First, we consider an OLS procedure. Next, we employ instrumental variables, esti- mating the model by TSLS and GMM techniques, with the covariance matrix computed according to Newey and West (1987) 1 . The use of instrumental variables aims to keep consistency when the regressor is correlated with the...
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This note was uploaded on 01/24/2011 for the course ACCT 201 taught by Professor Iker during the Spring '08 term at Susquehanna.
- Spring '08
- Managerial Accounting