An assessment of the relative importance of real interest rates, inflation and term premia in determining the prices of real and nominal UK bonds.

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 01 April 1995

Staff working paper No. 32
By David G Barr and Bahram Pesaran

We use a vector autoregression to decompose the causes of unanticipated movements in bond prices into news about fundamentals (expected future real interest and inflation rates) and expected future risk premia. This decomposition is applied to UK short- and long-maturity nominal bonds, and to UK index-linked (i.e. approximately real) bonds. We also examine the causes of changes in relative conventional and real bond prices. The results suggest that for both bond types, real-rate news plays an insignificant role, and that even for 'real' bonds it is dominated by news about inflation. Both bonds are strongly influenced by news about future risk premia, but these appear to be a common factor which has little influence on relative prices. It seems that news about inflation dominates relative price movements, and that such movements provide a reliable source of information about inflation expectations.

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