An Assessment Of The Relative Importance Of Real Interest Rates, Inflation, And Term Premiums In Determining The Prices Of Real And Nominal U.K. Bonds

Abstract

We use a vector autoregression (VAR) to decompose unanticipated bond returns into news about fundamentals (expected real interest and inflation rates) and expected risk premiums. This decomposition is applied to U.K. short- and long-maturity nominal bonds, and to U.K. index-linked bonds. We also examine the sources of relative conventional and real bond returns. The results suggest that for both bond types, real-rate news plays an insignificant role, and that even for “real” bonds inflation news is important. Both bonds are strongly influenced by news about future risk premiums, but these appear to reflect a common factor that has little influence on their relative returns. News about inflation dominates unanticipated relative returns, which appear to provide a reliable source of information about inflation expectations. © 1997 by the President and Fellows of Harvard College and the Massachusetts Institute of Technology