Deriving Estimates of Inflation Expectations from the Prices of UK Government Bonds

Abstract

Bonds with payments linked to the Retail Price Index were first issued in the United Kingdom in 1981 and now account for a significant proportion of the total UK government bond market. This paper discusses various methods by which prices of these indexed bonds can be compared with prices of conventional bonds to infer market expectations of future inflation, and in particular outlines the approach currently used to produce the inflation term structure published in the Bank of England's Inflation Report. There are a number of estimation difficulties - both theoretical and practical - in deriving such term structures and therefore a number of caveats that should be borne in mind when interpreting such measures of expectations.

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