An assessment of the relative importance of real interest rates, inflation and term premia in determining the prices of real and nominal UK bonds

This paper uses a dynamic accounting identity developed by Campbell to decompose movements in bond prices into elements due to changes in real interest rates, expected term premia and expected inflation. This decomposition is applied to UK short and long-maturity nominal bonds and index-linked bonds using data between 1983 and 1993. The main findings are that changes in expected inflation are by far the most important determinant of bond price movements. So much so that even for index-linked bonds changes in expected inflation (which have an effect due to the eight month indexation lag) are a more important factor than changes in real interest rates (which contribute less than 3% to the variance of index-linked bond prices). The paper also finds that changes in expected term premia are an important determinant of changes in both nominal and index-linked bond prices. However, the term premia appears to be a common factor which has little influence on the relative price of the two types of bond (ie break-even inflation rates). This suggests that changes in the relative price of the two type of bonds offer a reliable measure of changes in market expectations of inflation with about 95% of the variance of relative yields being due to revisions to expected inflation.