Working paper no. 97: Extracting inflation expectations and risk premia from the breakeven inflation rate in Iceland

The Central Bank of Iceland has published the working paper "Extracting inflation expectations and risk premia from the breakeven inflation rate in Iceland" by Þórarinn G. Pétursson, chief economist at the Central Bank.

The yield spread between a conventional nominal bond and a corresponding inflation-indexed bond – the so-called breakeven inflation rate – is a common measure of investors’ inflation expectations. But the spread also includes two risk premia that can distort the breakeven rate as a measure of inflation expectations. In this paper a signal-extraction approach is used to jointly estimate underlying inflation expectations and the inflation and liquidity risk premia from Icelandic data on 2-year breakeven inflation rates. The estimated 2-year inflation expectations are much smoother than the breakeven rate and remain above the official 2.5% inflation target for most of the sample period. The two risk premia are found to be large and time-varying, highlighting the need for caution when interpreting the breakeven rate as a direct measure of inflation expectations. It is concluded that the three subcomponents of the breakeven rate react differently to an unanticipated monetary tightening. The tightening leads to a gradual and persistent decline in inflation expectations and the inflation risk premium partly offset by a temporary increase in the liquidity premium, consistent with the “risk-taking” channel of monetary policy.

The working paper can be accessed here: Extracting inflation expectations and risk premia from the breakeven inflation rate in Iceland

Dataset: Datafile for the paper

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