Working Paper No. 75
By Francis J Breedon and Jagjit S Chadha
This paper examines the inflation forecasting performance of the inflation term structure (ITS) derived by the Bank from conventional and index-linked bonds. We find that the ITS: (i) gives a somewhat better measure of market expectations of inflation than the nominal yield curve alone and (ii) is at least comparable with published inflation forecasts from a number of commercial and academic institutions. But inflation forecasts from the ITS have a tendency to over predict the level of future inflation which has meant that, in the period we examine, index-linked bonds have proved, ex post, to be a cheap form of funding relative to nominal bonds. This overprediction may arise from either an inflation risk premium and/or expectational errors - we cannot be sure which on the evidence.