An argument that U.S. inflation expectations are better measured by comparing U.S. treasury bonds with British "gilts" -- marketable securities linked to a broad index of retail prices -- than by surveys or econometric models.Great Britain ; Bonds - Great Britain

Ann M. Dombrosky

Joseph G. Haubrich

English

Research Papers in Economics

June 1, 1992
eOONOMIG
GOMMeiMTCIRY
Federal Reserve Bank of Cleveland
Gilt by Association:
Uncovering Expected Inflation
by Joseph G. Haubrich and Ann M. Dombrosky
"ne unfortunate aspect of life in the
United States today is that guesses about
inflation really matter. We have to con-
sider expected changes in the cost of
living when negotiating our wages. Sim-
ilarly, we need to think about future in-
flation when computing both the returns
to investing and the cost of borrowing.
Explicitly or implicitly, inflation expecta-
tions have become an integral part of all
our economic decisions.
Errors in estimating inflation can be
costly — so costly, in fact, that many
analysts think such miscalculations may
be a major source of disturbance in the
economy. For instance, an unexpected
decline in the rate of inflation can tem-
porarily increase the jobless rate: If
labor contracts call for wage hikes
based on a particular inflation rate, but
actual inflation turns out to be lower,
layoffs, strikes, or costly contract re-
negotiations may ensue. In fact, infla-
tion expectations may be the bridge
that links changes in the price level to
business activity. If so, policymakers
need to know how people predict fu-
ture inflation in order to evaluate how
shifts in the inflation trend will impact
the economy.
In this Economic Commentary, we dis-
cuss a number of ways to estimate ex-
pected inflation, concentrating on the
advantages of using "gilts," British gov-
ernment bonds indexed for price-level
changes. We argue that this market-
based measure implies a different —
and we believe more accurate —
pattern of expected inflation than either
statistical techniques or surveys. Expecta-
tions adjusted faster and real interest rates
were higher than commonly supposed.
Consequently, the effects of many deci-
sions, including fiscal and monetary pol-
icy, may need to be reevaluated.
• Estimating Expected Inflation
There are several methods of measur-
ing the expected inflation rate, but each
has limitations. Perhaps the most popu-
lar measures are based on survey data.
One of the most frequently cited of
these is the Livingston survey of profes-
sional economists. Two other promi-
nent surveys, conducted by the Univer-
sity of Michigan and The Conference
Board, track the inflation expectations
of households and business executives,
respectively.
Though widely used, survey data can
be biased. The trader with a hot tip
may not want to share it, and the busy
executive with a company to run may
be too pressed for time to reply. More-
over, surveys rarely weight an individ-
ual's stake in predicting inflation accu-
rately. The homeowner looking to
refinance a mortgage is given the same
weight as a civil servant with an in-
dexed salary.
Econometric models designed to approx-
imate inflationary expectations also have
flaws, principally their failure to capture
the richness of the expectations process.
The myriad of prices that people face in
their day-to-day lives, coupled with the
Economists traditionally use surveys
and econometric models to measure in-
flation expectations, but surveys can be
biased, and statistical techniques may
fail to capture the complexity of indi-
vidual decisions. In this Economic
Commentary, the authors suggest a
market-based alternative that tracks
inflation expectations in the United
States by comparing U.S. Treasury
bonds with British "gilts," marketable
securities linked to a broad index of
retail prices.
complex and idiosyncratic way in which
they form judgments about future infla-
tion, raises considerable doubt about the
ability of these models to mimic actual
expectations.
Because we cannot observe expected
inflation directly, it is difficult to test
between these alternative measures:
Are they bad guesses of people's expec-
tations, or are people's expectations
bad guesses of inflation?
Financial markets provide a third and,
we argue, more reliable way to deter-
mine people's beliefs about future infla-
tion. Market participants have a stake
in predicting inflation accurately. They
put their money where their mouth is in
the sense that a correct call can mean
the difference between driving a BMW
or a Yugo. The market also weights
ISSN 0428-1276players' convictions by their "dollar
votes," which reflect the confidence
and stake people have in their predic-
tions. Though some traders may be irra-
tional or ill-informed, smarter and
more-enlightened investors can profit
at their expense. In this sense, the mar-
ket as a whole produces more rational,
better-informed forecasts than its aver-
age participants.
Financial markets in the United States
do not easily reveal an expected infla-
tion rate, however, since the heavily
traded instruments are all based on
nominal rates of return. Fortunately,
another channel is available. We can
look across the Atlantic to England,
where some government bonds are in-
dexed for inflation. Below, we com-
pare one of these bonds with U.S.
Treasury securities of like maturity in
order to determine inflationary expecta-
tions in the United States.
• Using Gilts
In March 1981, the British government
began issuing marketable bonds, called
gilt-edged securities, or gilts, linked to
a broad index of retail prices (the RPI).
Both the semiannual coupon and the
principal are scaled up by changes in
this index, with the currently outstand-
ing set maturing in 1994, 1996, 2001,
2003, 2006, 2009, 2011, 2013, 2016,
2020, and 2024.
Indexed gilts present an opportunity to
measure the real interest rate — and
hence inflation expectations — in
Britain. Then, if arbitrage between the
U.S. and British capital markets keeps
real interest rates in the two nations
equal, these securities may also provide
useful information about inflationary
expectations in the United States.
Unfortunately, the yield on indexed gilts
does not reveal the real interest rate
directly. An eight-month lag in indexing,
coupled with various tax differences be-
tween indexed and nonindexed gilts,
makes unraveling this figure a complex
procedure (see box).
One inconvenience associated with this
procedure is that it rarely uncovers
short-term real interest rates. It cannot
reveal rates shorter than the next matur-
ing indexed gilt, and the limited num-
ber of gilt issues means that this is
often several years down the road. Con-
sequently, only longer-term inflation
expectations can be measured. On the
other hand, this approach does provide
a real term structure for long rates.
Once we know the real interest rate, we
can simply subtract it from the nominal
yield to disclose the expected rate of in-
flation. But this measure is not perfect,
since it fails to account for the inflation
premium. If people value the protec-
tion against inflation that indexed gilts
provide, they will drive up the price
and drive down the yield. Hence, the in-
flation expectation term includes not
only true expectations of inflation, but
the inflation premium as well.
5
Using British gilt data to uncover infla-
tion expectations in the United States
depends crucially on equal real interest
rates in the two countries. Arbitrage
promotes such interest parity, but mar-
ket imperfections, tax differences, and
exchange-rate risk work against it.
Some researchers have suggested that
real rates do indeed differ across coun-
tries, basing their conclusion on two
different types of tests. One type looks
at ex post real-rate differences, while
the other uses estimates of real rates. In
both cases, the results are quite sensi-
tive to the assumptions made in setting
up the tests. For tests that look at the
predictability of ex post real-rate differ-
ences, rejecting interest equality statisti-
cally does not necessarily mean that
the difference between U.S. and British
real interest rates is large. For tests that
estimate the real rate, the results depend
crucially on what we know is an imper-
fect procedure. Either way, while they
introduce a note of caution, these find-
ings still suggest that real interest-rate
equality is plausible.
DETERMINING REAL
INTEREST RATES FROM
INDEXED GILTS
The yield on indexed gilts does not
directly reveal the real interest rate,
since these securities are indexed to
the RPI with an eight-month lag. The
base for indexation is the RPI eight
months before the issue date, wilh
each semiannual coupon scaled up by
the increase in the index from the
base month to eight months prior to
the coupon date. This same lag ap-
plies to the principal. A gilt issued in
March 1982, for example, is based on
the RPI for July 1981. The first
coupon, payable in September 1982,
is scaled up by the increase in the RPI
from July 1981 to January 1982, and
the principal, payable in March 1988,
is scaled up by the change from July
1981 to July 1987.
The eight-month lag introduces infla-
tion risk into the indexed gilts. The
yield on an indexed gilt with one year
left to maturity is contaminated with
eight months of unknown inflation —
a risk borne by investors. However,
the lag makes little difference in look-
ing at very long rates.
There is a simple way around this
problem. Nonindexed gilts of like ma-
turity exist whose price also depends
on the real interest rate and expected
inflation, but in very different ways.
Essentially, it is a problem of two
equations and two unknowns, and we
can back the real interest rate out of
the market by using both securities.
This procedure is complicated by the
fact that the tax treatment differs be-
tween indexed and nonindexed gilts,
with increases in principal value of
the former being counted as a capital
gain. Though messy, it is possible to
correct for this problem through a
detailed comparison of different types
ofgilts.
a
a. For one method of correction, see G.
Thomas Woodward (footnote 3). We use
Woodward's calculation for the real inter-
est rate to construct figures 1 and 2.FIGURE 1 MEASURES OF EXPECTED AND ACTUAL INFLATION
Percent
10
8 -
6 -
4 -
.
1
.
1
-
. . . 1 . . . i
DRI
^^
As
y—>
iii
—--^_
v V
i ,
"^ ^
. . i
CPI
"•\ /
. Y 1
'Gilt
. . .
^/
, . . 1 0
1982 1983 1984 1985 1986 1987
FIGURE 2 DIFFERENCE BETWEEN EXPECTED INFLATION MEASURES AND ACTUAL INFLATION
1988 1989
1982 1983 1984 1985 1986 1987 1988 1989
NOTE: The gilt data are based on the difference between the pretax real interest rate on British indexed gilts and the nominal interest rate on U.S. Treasury bonds issued
or traded during the quarters plotted and maturing as follows: 1982:IIQ-1986:IQ issues mature in 1988:IQ; 1986:IIQ-1987:IQ issues mature in 1990:IQ, and 1988:IQ-
1989:IQ issues mature in 1992:IQ. The DRI and CPI data are the annualized percentage increases in those series over the same intervals. Dotted lines represent breaks in
the maturity dates.
SOURCES: U.S. Department of Labor, Bureau of Labor Statistics; DRI/McGraw-Hill; and G. Thomas Woodward, "The Real Thing" (footnote 3).
To illustrate the gilt measure of expected
inflation, figure 1 plots the difference be-
tween the British real interest rate and the
yield on U.S. Treasury bonds over the
1982-89 period, comparing U.S. bonds
and British gilts having the same expira-
tion date. For reference, we also include
DRI's model-based prediction of infla-
tion over the same interval.
• Results
Note that the gilt measure and the DRI
forecast follow broadly similar patterns,
declining in the early 1980s, leveling off,
and then increasing in the closing years
of the decade. However, with few excep-
tions, the gilt measure reveals a lower ex-
pected inflation rate, and thus a higher
real interest rate, than the forecast gener-
ated by the DRI model.
7
Figure 2 plots the difference between
the CPI and both measures of expected
inflation. Our hope is that the results
suggest the disquieting idea that other
standard projections may also substan-
tially mismeasure people's expectations
of inflation. We raise this just as a con-
jecture — gilts do not have a long enough
track record to allow for a rigorous test.
Nonetheless, we note that the average dif-
ference between the gilt measure and the
CPI is only one-fifth the difference be-
tween the DRI forecast and the CPI.
Moreover, the gilt measure shows that in-
flationary expectations converge toward
actual inflation rates faster than the
model-generated forecasts.
• Conclusion
Comparing U.S. bonds with British
gilts provides an enlightening look at
expected inflation. If, as we suggest,
gilts more accurately reflect actual in-
flation expectations than either econo-
metric models or household surveys,
what are the implications for U.S.
policymakers?
First, in terms of levels, the gilt meas-
ure implies that expected inflation was
lower here in the 1980s than commonly
supposed. This means that the wage and
price changes witnessed during the dec-
ade were more reflective of real gains
than of inflation expectations. Likewise,
when we consider the influence of fis-
cal and monetary policies, the lower
expected inflation reveals more real ef-
fects. In particular, it indicates that ex-
pected real interest rates were higher
during the 1980s than suggested by
other measures.Second, it appears that inflation expec-
tations are adjusted more rapidly than
economists believed, underscoring the
idea that people understand the infla-
tionary process reasonably well and
respond quickly to changes in the
stance of monetary policy. This sug-
gests that, over the course of the
decade, monetary policy may also have
had less of an impact on business ac-
tivity than previously supposed.
In sum, the British indexed gilt market
provides a novel and potentially useful
measure of expected inflation. Yet,
there's "many a slip 'twixt the cup and
the lip": Gilts do not reveal short-term
expectations, interest rates may differ
between the United States and Britain,
and the RPI is not the CPI. Issuing
short-maturity indexed bonds in the
United States could provide a more di-
rect and more accurate measure. How
viable or successful such a market
would be, however, is a question for
o
further studies.
• Footnotes
1. A large body of literature evaluates the
"rationality" of these surveys. A particularly
good summary and further references can be
found in Michael F. Bryan and William T.
Gavin, "Comparing Inflation Expectations of
Households and Economists: Is a Little
Knowledge a Dangerous Thing?" Federal
Reserve Bank of Cleveland, Economic
Review, Quarter 3 1986, pp. 14-19.
2. The nominal rate of return equals the real
rate of return plus the expected inflation rate.
If we knew the real interest rate, we could
easily determine the inflation expectation by
calculating the difference between the nomi-
nal return and the real return. One excellent
paper that uses only nominal rates is Richard
H. Jefferis, Jr., "Expectations and the Core
Rate of Inflation," Federal Reserve Bank of
Cleveland, Economic Review, vol. 26, no. 4
(1990 Quarter 4), pp. 13-21.
3. For another view of the British indexed
bond market, see G. Thomas Woodward, "The
Real Thing: A Dynamic Profile of the Term
Structure of Real Interest Rates and Inflation
Expectations in the United Kingdom, 1982-
89," Journal of Business, vol. 63 (July 1990),
pp. 373-98; and Gabriel de Kock, "Expected
Inflation and Real Interest Rates Based on
Index-Linked Bond Prices: The U.K. Experi-
ence," Federal Reserve Bank of New York,
Quarterly Review, vol. 16, no. 3 (Autumn
1991), pp. 47-60. de Kock argues that gilts are
poor predictors of inflation, yet despite stacking
the deck against this measure (he uses overlap-
ping prediction intervals, employs gilt forecasts
of inflation to 1996 as one-year projections, and
fails to account for tax effects), he finds that it
often outperforms autoregressive models.
4. For a more detailed look at the origins
and mechanics of the indexed gilt market,
see Roger Bootle, Index-Linked Gilts: A
Practical Investment Guide. Cambridge,
England: Woodhead-Faukner, 1985.
5. Other methods of determining inflation ex-
pectations, including surveys and econometric
models, usually have the opposite problem,
impounding the inflation premium in the real
interest rate. These methods estimate expected
inflation so that the unobserved inflation pre-
mium is attributed to the real rate.
6. For a thorough review of interest equality,
see Frederic S. Mishkin, "Are Real Interest
Rates Equal across Countries? An Empirical
Investigation of International Parity Condi-
tions," Journal of Finance, vol. 39, no. 5
(December 1984), pp. 1345-57.
7. It is not our intention to disparage DRI's
prediction of the Consumer Price Index (CPI).
Rather, we use this forecast because it is pop-
ular, well respected, and readily available.
8. For a prominent and well-argued recent
proposal, see Robert L. Hetzel, "Indexed
Bonds as an Aid to Monetary Policy," Fed-
eral Reserve Bank of Richmond, Economic
Review, vol. 78, no. 1 (January/February
1992), pp. 13-23. Athorough discussion of
many of the issues involved can be found in
G. Thomas Woodward, "Should the Treasury
Issue Indexed Bonds?" Congressional Re-
search Service Report No. 84-713E, Wash-
ington, D.C.: Library of Congress, 1984.
Joseph G. Haubrich is an economic advisor
and Ann M. Dombrosky is a senior research
assistant at the Federal Reserve Bank of
Cleveland.
The views stated herein are those of the
authors and not necessarily those of the Fed-
eral Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve
System.
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
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Gilt by association: uncovering expected inflation

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Gilt by association: uncovering expected inflation

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