Are Real Rates of Interest Negative? Implications for Expected Inflation

Abstract

Ever since the start of the COVID-19 pandemic, real yields on inflation-protected government debt have shifted to the negative. First, and trivially, this article argues that irrespective of the specific assumptions about the stochastic nature of the underlying parameters, the observable yields are sensitive to nonstochastic factors that require only minor adjustments. More important, if real bonds only partially reflect the expected inflation (i.e., negative real rates of interest), this may create a quasi-arbitrage opportunity if the probability of negative inflation, as perceived by market participants, is nil. Therefore, the magnitude of the intertwined real rates, inflation risk premiums, and expected inflation are estimated empirically. The inflation risk premium has increased dramatically during the period in which the rates shifted to the negative. Interestingly, the highest levels of the inflation risk premium correspond to the second and fourth peaks of the COVID-19 pandemic.