Modeling Inflation Expectations in the U.K. Open Access
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Literature on inflation expectations generally falls into two streams: (1) a financial approach which treats index-linked bonds as a purely financial tool and models the term structure of inflation expectations based on unobserved factors, and (2) a macroeconomic approach which treats breakeven inflation as the measure of expected inflation and models it based on economic fundamentals. This work aims to build a link between the two streams of literature by modeling inflations expectations in the U.K. using business cycle variables, liquidity indicators, and monetary regimes. I find that monetary policy regimes are most useful in explaining inflation expectations. Business cycle variables affect inflation expectations only in the period preceding the introduction of inflation targeting, which means that inflation targeting improved central bank credibility. Liquidity preferences and market segmentation have a pronounced impact on inflation expectations only during periods of large differences in issuances and trading volumes. Inflation risk premia usually increase during periods of abnormal inflation.