CORE INFLATION, INFLATIONARY EXPECTATIONS AND BOND YIELD DETERMINATION

This research has examined the relationship between inflationary expectations and bond yield determination by using a specially constructed inflationary expectations variable, the Core Inflation Rate. In the context of six bond yield models, this studys finds that the Core Inflation Rate, when compared to the traditional adaptive expectations formulation, is a good but not a superior measure of expectations. It is shown how the Core Inflation Rate is constructed and a justification is given for its use as an inflationary expectations variable.;Specific hypotheses in this study are: (1) Expectations of inflation are formed in a mixed autoregressive/extrapolative manner. (2) Bond yields adjust with a short lag to changes in inflation compared to some earlier studies. (3) The Core Inflation Rate is a 'best' predictor of inflationary expectations in the succeeding quarter.;Ordinary Least Squares, single equation estimates are obtained for two versions of each of the six bond yield models: one with the Core Inflation Rate as a measure of inflationary expectations and one with the traditional adaptive mechanism.;Specific findings from the research are: (1) Expectations formation contains a significant autoregressive component. (2) Using ex-post forecasting and within sample tracking techniques, it is shown that all models significantly underpredict bond yields in the quarters of 1980. (3) The best model in terms of tracking and ex-post forecasting properties is a term structure model using the Core Inflation Rate. (4) Various money supply variables do not have a strong effect on bond yields.;An important hypothesis of this work is that in periods of supply shock and excess demand inflation, forecasts of inflation should adjust more slowly than the adaptive mechanism allows. The Core Inflation Rate effectively captures this slow adjustment and should be an excellent proxy for inflationary expectations.;The results imply that the dominant component of nominal bond yields is the inflationary expectations premium. Only policies aimed at reducing the Core Inflation Rate will lower bond yields.