Estimating Inflation Expectations Using French Government Inflation-indexed Bonds

Ana del Río * We wish to thank Juan Ayuso, Fernando Restoy and participants in the seminar held at the Banco de España, especially Liliana Toledo, for helpful comments and suggestions. Abstract Inflation-indexed bonds are fixed-income securities whose nominal cash flows are adjusted to an inflation index. In countries where these securities exist, inflation expectations are sometimes estimated as the spread between the nominal yield on a conventional bond and the real yield on an indexed bond with a similar maturity and issued in the same currency and by the same issuer. However, this indicator, known as the break-even rate, may estimate inflation expectations with some biases. In this paper, we discuss, and quantify where possible, the size of such biases. Then, focusing on the 10-year French indexed bond, we compute an alternative indicator, called the inflation compensation measure, which corrects some of these biases and find very few differences between both indicators in our sample period. Finally, the comparison with other indicators of long-term inflation expectations shows that measures based on indexed-bond prices are more time-varying than non-financial indicators, but less variable than other financial indicators. Inflation-indexed bonds (indexed bonds hereafter) are fixed-income securities whose nominal cash flows are adjusted to inflation. While nominal payments are known ex-ante in a conventional bond, and real payments depend on inflation; the opposite occurs in the case of indexed bonds 1. Indexed-bond markets have traditionally emerged in countries experiencing very high rates of inflation. In these cases, the issuance of indexed debt by the government has commonly been aimed at developing long-term capital markets and improving the credibility of anti-inflation policies. This has been the case, for example, in Israel, Brazil, Mexico or Argentina. More recently, indexed-bond markets have also emerged in a number of industrialised countries, with moderate inflation rates and with price stability-oriented monetary policies. and New Zealand, where indexed-bond markets have sought to reduce debt costs, to complete financial markets and to reinforce the credibility of non-inflationary policies. Financing through indexed, as opposed to conventional, bonds may reduce the cost of debt through different channels. Firstly, if investors demand an inflation-risk premium on conventional bonds, the issuer of indexed bonds will save this premium in exchange for bearing the inflation risk. If the issuer is less risk-averse than the investors, the resulting cost-risk combination must be superior. Secondly, issuing indexed bonds may further reduce the expected cost of debt …