Estimating the New Keynesian Phillips Curve for the UK: evidence from the inflation-indexed bonds market

This paper utilizes the information in the inflation-indexed bonds market to estimate the New Keynesian Phillips Curve for the UK using an unobserved component approach. The main advantage of this approach comes from using the Kalman filter to explicitly estimate the unobserved expected inflation from the observed break-even inflation rates – the yield difference between the inflation-indexed bonds and the nominal bonds. Our results show that the expected inflation estimated from the unobserved component model plays a significant role in explaining the inflation dynamics in the UK. The evidence also suggests that the estimated inflation expectations are better able to capture the evolution of actual inflation process as compared to the break-even inflation rate as a proxy for expected inflation.

Inflation Indexed Bonds

In 2013–14, the Indian government issued Inflation Indexed Bonds for institutional investors and Inflation Indexed National Savings Securities for retail investors. The immediate trigger for the issue of inflation indexed securities was the coincidence of an increase in trade deficit, an increase in gold imports and a period of high inflation, leading policy makers to conclude that households were increasing their gold holdings as a hedge against inflation. It was expected that investors would use the Inflation Indexed Bonds to hedge against inflation and reduce their demand for gold. However, response to the inflation indexed securities was poor and the issue was not considered a success. The government must now decide whether this was a case of wrong policy or wrong execution.