Inflation risk in the U.S. yield curve: the usefulness of indexed bonds

The inflation-indexed bonds the U.S. Treasury plans to issue will reduce the expected borrowing cost if the yield curve reflects a risk premium for inflation. In the United Kingdom, indexed bonds are also used to extract inflationary expectations and thus to guide monetary policy. The bonds will produce a more reliable measure of such expectations if the inflation risk premium is taken into account. We estimate such a risk premium for the United States by means of a two-factor affine-yield model of the term structure. The model allows both the inflation risk premium and real term premium to vary over time. Using monthly data on CPI inflation and on bond yields for two-year to ten-year maturities, we find both premia to have been significant for the sample period January 1984 to July 1996. We estimate that indexed bonds would have saved an average of one-fifth of the expected borrowing cost of 10-year notes.