How Risk Premia in Inflation Derivatives can Guide Monetary Policy

The gap between market forecasts of inflation and where inflation will likely go may be a feature, not a bug. This gap is a risk premia that can be informative about what scenarios are worrisome to investors, and as such may be useful for policy makers deciding on how to weight the relative costs of inflation and deflation.

Justin Wolfers’ recent recent NYT article on inflation expectations sets the stage. In this article, he walks through an academic asset pricing paper that estimates a probability distribution for future inflation based on the prices of bets on inflation. The basic idea is that there is a betting market in which people can place bets on where they think inflation will be going. Just like how a bookie’s prices say something about the probability of certain horses winning a race, the prices on this betting market (otherwise known as a derivatives market) make statements about the probability inflation ends up in certain zones. Justin summarizes the findings:

While traders view inflation of roughly 2 percent as the most likely outcome, the market is also telling us the probability of other levels of inflation — or deflation. And it is saying that the risks of missing the 2 percent target are extremely unbalanced: It is twice as likely that inflation will come in below the Fed’s target as above it.

But there’s another aspect to asset prices that isn’t as important for horse races: risk premia. Whether inflation is high or not is related to the strength of the jobs market and the economy as a whole. In particular, if I were to tell you that there was going to be deflation in two years, your best prediction would be that we were going through a double dip recession in which aggregate demand fell. This is clearly bad, and as such you would be willing to buy insurance against this scenario. In the language of horse betting, you would be willing to pay better than fair odds that there will be deflation. Sure you might lose money on average, but when deflation hits and you lose your job, at least you got your racetrack winnings to cushion the blow.

As such, the market forecast is equal to the true future expected inflation plus a risk premium that reflects whether low inflation or high inflation scenarios are scarier. If people are scared of a Japan style deflation, then the market forecast will underestimate true inflation. If on the other hand people are worried about 1970’s style stagflation, the market forecast will overestimate true inflation.

While this can be a nuisance if you want to get the “best” physical forecast of actual inflation, it can actually be tremendously valuable for policy makers who need to decide on whether to be more worried about the costs of high inflation or low inflation scenarios. Sure, if you’re playing a game and trying to minimize your prediction error the market forecast might not be helpful. But this can be very useful for policy! Negative risk premia on inflation expectations tell policy makers that low inflation scenarios are much worse than high inflation scenarios. If this is the case, then the inflation target has reason to be asymmetric — better to avoid scary deflation than deal with temporarily higher inflation.

As a more general point, this risk premia analysis shows how asset pricing is in some ways a form of quantitative psychology. Estimating risk premia can be interpreted as answering the question “based on these asset returns, what does that say about the kind of events that scare people”? And once policy makers know about these feared scenarios, they can adjust policy to make sure they do not come to be.

2 thoughts on “How Risk Premia in Inflation Derivatives can Guide Monetary Policy

  1. Yichuan Wang Post author

    From the article it seems like they are talking about inflation caps and floors. So you can think of them as options on the TIPS spread, and not just the TIPS bond itself.

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