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Inflation: risk without premium

Historically, securities that lose value as inflation increases have paid a sizable risk premium. However, there is evidence that inflation risk premia have vanished or become negative in recent years. Macroeconomic theory suggests that this is related to monetary policy constraints at the zero lower bound: demand shocks are harder to contain and cause positive correlation between inflation and growth. Assets whose returns go down with higher inflation become valuable proxy-hedges. As a consequence, inflation breakevens underestimate inflation. Bond yields would rise disproportionately once policy rates move away from the zero lower bound.

Gourio François and Phuong Ngo (2016), “Risk Premia at the ZLB: a macroeconomic interpretation”, Working Paper.

The post ties in with this sites lectures on non-conventional monetary policies (particularly the consequences of zero lower bound) and on information efficiency through fundamental value research (for fixed income markets).

The below are excerpts from the paper. Headings and some other cursive text has been added for context and convenience of reading.

A significant change

“Historically, high inflation [had been] associated with low stock returns and typically low growth, leading investors to fear inflation…Since 2008, inflation [has been] associated with high stock returns, and hence investors appear to view inflation positively. We… show how the zero lower bound on nominal interest rates can explain this change in correlation. The effects of demand shocks on inflation and output [producing positive output-inflation correlation] are amplified since monetary policy may be unable to offset them, while the effects of supply shocks on output [producing negative output-inflation correlation] are weakened because monetary policy may be unable to accommodate them.”

Negative inflation risk premia: the macroeconomic story

“A fairly standard New Keynesian macroeconomic model generates positive inflation risk premia in normal times (far from the zero lower bound), but negative inflation at the zero lower bound.”

“Standard macroeconomic models suggest that the response to aggregates shocks is different when the ZLB [zero lower bound for interest rates] binds. Demand shocks may have little effect on inflation or economic activity if the ZLB does not bind because the central bank can offset demand fluctuations by changing the interest rate. But the same demand shocks may have large effects if the ZLB binds and the central bank cannot respond…Similarly, supply shocks may have larger effects on output if the ZLB does not bind, and smaller effects on inflation, because monetary policy cannot accommodate them.”

“This change in the response to shocks affects the covariance of marginal utility and inflation and consequently the inflation risk premium…Where demand shocks dominate…low consumption is associated with low inflation, while…in the case where supply shocks dominate: low consumption is associated with high inflation. This covariance determines the inflation risk premium [in mainstream consumption-based asset pricing models]…The key result of this paper is that the covariance of consumption and inflation changes as the economy operates close to the ZLB.”

“The inflation risk premium is the difference between [inflation] breakevens and expected inflation…Inflation breakevens are the difference between the log nominal yield and the log real yield [as priced in financial markets]…Intuitively, if the covariance of growth and inflation is negative supply shocks dominate, and breakevens overestimate inflation. Nominal bonds are risky assets, since their real payout is low in states of the world where inflation is high, which on average coincide with low consumption growth and high marginal utility. Hence, agents require a premium to hold nominal bonds, so the nominal yield is higher than it would be under risk-neutrality. On the other hand, if the covariance of growth and inflation is positive; demand shocks dominate, inflation is a hedge, and breakevens underestimate inflation.”

Negative inflation risk premia:  the empirical evidence

“We document that there has been a significant change in the response of stock prices to inflation in the United States after 2008. Historically, high inflation is associated with low stock returns. But since 2008, stock prices appear to react positively to inflation. As a simple illustration, [the figure below] depicts the strong correlation between stock prices and the 10-year breakeven (the difference between the yield of a 10-year nominal Treasury bond and a 10 year indexed Treasury bond) between 2009 and 2013. During this period, increases in stock prices – which typically reflected positive assessment of the economic recovery – were also associated with increases in inflation breakevens.”

“[The figure below] plots the daily changes in S&P500 versus the daily changes in breakevens. The left panel demonstrates that in the 2003-2007 sample, the correlation is essentially zero. The right panel shows that the correlation becomes very strong after 2009…the results with one-day inflation swaps are very similar to those with breakevens.”

“The change in the correlation suggests that the inflation risk premium is now negative, consistent with other indirect measures such as term structure models estimates…Note that the risk of inflation depends (in a consumption based model) on the covariance of inflation and consumption growth…In a world where supply shocks dominate, this covariance is strongly negative, investors fear inflation, and the risk premium for bearing inflation risk is positive. But in a world where demand shocks dominate (e.g. because of the ZLB), this covariance is positive, and the inflation risk premium may be negative.”

The consequences of negative inflation risk premia

“Our model suggests that an upturn in the economy or in inflation may lead to a significant increase in interest rates because  these risk premia change as the ZLB becomes less of a constraint.”

“Our model argues that breakevens underestimate expected inflation when the economy operates close to the ZLB, but overestimate expected inflation when the economy is far from the ZLB.”


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