Abstract - The Term Structure of Inflation Forecasts
We build a four-factor term structure model of inflation forecasts. The model accommodates forecasts over multiple horizons from multiple surveys and Treasury yields by allowing for differences between risk-neutral, subjective, and objective probability measures. We document that surveys overpredict inflation the most and disagree the least at the end of recessions. A model that restricts the subjective and objective measures to be the same cannot be statistically distinguished from a larger model. This restricted model dominates a standard yield-only macro finance model in implied inflation expectations, Fisher-equation-based decompositions of nominal yields, and out-of-sample forecasting of inflation and yields. Model-implied inflation expectations load on inflation, real activity and only one of the two latent factors, which is correlated with survey forecasts. Nominal yields load on all four factors implying that information in yields is compatible with that in surveys. The out-of-sample version of our model suggests that monetary policy became effective over time.
London Business School