INFLATION, REAL INTEREST-RATES, AND THE BOND MARKET - A STUDY OF UK NOMINAL AND INDEX-LINKED GOVERNMENT BOND PRICES

This paper estimates expected future real interest rates and inflation rates from observed prices of UK government nominal and index-linked bonds, The estimation method takes account of imperfections in the ind exation of UK index-linked bonds. It assumes that expected log returns on all bonds are equal, and that expected real interest rates and inf lation follow simple time-series processes whose parameters can be est imated from the cross-section of bond prices. The extracted inflation expectations forecast actual future inflation more accurately than nom inal yields do. The estimated real interest rate is highly variable at short horizons, but comparatively stable at long horizons, Changes in real rates and expected inflation are strongly negatively correlated at short horizons, but not at long horizons.