DP6809 The Term Structure of Inflation Expectations

Author(s): Mikhail Chernov , Philippe Mueller

Publication Date: April 2008

Keyword(s): inflation , macro-finance term structure model , monetary policy , survey forecasts

JEL(s): C50 , E52 , G12

Programme Areas: Financial Economics

Link to this Page: www.cepr.org/pubs/dps/DP6809.asp.asp

We use evidence from the term structure of inflation expectations implicit in the nominal yields and survey forecasts of inflation to address the question of whether or not monetary policy is effective. We construct a model that accommodates forecasts over multiple horizons from multiple surveys and Treasury yields by allowing for differences between risk-neutral, subjective, and objective probability measures. We extract private sector expectations of inflation from this model and establish that they are driven by inflation, real activity and one latent factor, which is correlated with survey forecasts. We show that the interest rate responds to this "survey" factor. The inflation premium and out-of-sample estimates of the inflation long-run mean and persistence suggest that monetary policy became effective over time. As an implication, our model outperforms a standard macro-finance model in inflation and yield forecasting.