Evidence on inflation expectations from Canadian real return bonds

Starting with the UK in 1981, many of the industrialized countries have issued long-term bonds whose principal value is indexed to the rate of inflation. One of the benefits that economists predicted from issuing such bonds is that the difference between the yield on indexed and nominal bonds would be an indicator of the market’s expectations of inflation. This could be a useful guide for central banks in judging the success of their monetary policy in stabilizing the inflation rate. This paper examines the data from Canada, which began issuing indexed (“real return”) bonds in 1991. It is found that it is possible to explain the relationship between real and nominal bonds with very small residuals, using a moving average of historical inflation and the US bond yield as explanatory variables. The implication is that expectations in the nominal bond market are adaptive rather than forward looking. Therefore, while we are able to infer the market’s expectations of inflation with a high degree of precision, this is not actually very useful as a guide to monetary policy or predicting future inflation.