Risk-neutral distributions for inflation and their uses

Columbia University, New York NY

Investigators

Abstract

Inflation is an important macroeconomic phenomenon. Individuals, firms, and governments are concerned not just about the current inflation rate but also about future possible inflation levels. The PI team will use an innovative method to measure expectations about the future possible inflation rate. They will construct this measure from daily data on option contracts on the realized future inflation level; these options are now widely sold. The new measure will be created based on option sales between 2009 and 2013, with future horizons from 1 to 10 years ahead of the sales date, and will include measures for the entire distribution of future inflation in the US, the United Kingdom, the Euro area, and Japan. The PIs will then use these data to answer three different questions. First: How do we measure the fiscal capacity of a central bank? Second: Are expectations about future inflation levels well anchored? And (3) how large are the costs of inflation to total economic social welfare? The PIs will use the data to construct monthly risk-adjusted inflation distributions for the different horizons and areas. These are market-based forecasts of the entire distribution of future inflation. Because there are data both for average inflation over N years and for annual inflation for each of these N years, the data also include information on inflation dynamics. Measuring the fiscal capacity of a central bank requires calculating the market value of the bank's assets as well as calculating the present value of seigniorage revenues. The project will give estimates of the sensitivity of these values to higher inflation. The team will also compare their measures to survey-based measures of expectations about future inflation. Because they will be able to measure how much private agents appear to be willing to pay to remove all inflation risk, the measure will also let the team develop a new way to measure the welfare costs of inflation.