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Economic Quarterly

Summer 2006

Inflation Uncertainty and the Recent Low Level of the Long Bond Rate

Yash P. Mehra

This article constructs an empirical measure of uncertainty about short-term inflation forecasts and finds the long bond rate to be positively correlated with this empirical measure over 1984Q1 to 2004Q3. The positive correlation suggests that an increase in uncertainty about short-term inflation forecasts raises uncertainty about long-term inflation forecasts and hence may account for the presence of inflation risk premiums in bond yields. The results also indicate that, in recent years, the correlation of the long bond rate with short-term inflation uncertainty has weakened, which reflects increased confidence that inflation will remain low and stable, leading to lower inflation risk premiums and thereby explaining the current low level of the long bond rate.

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