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LIQUIDITY RISK PREMIA AND BREAKEVEN INFLATION RATES The yield differential between nominal and inflation indexed Treasury securities is one of several measures monetary policymakers use to gauge market expectations of future inflation. Accurately inferring market expectations of inflation from yield spreads, however, is difficult because of the differences in market liquidity conditions between the securities. In “Liquidity Risk Premia and Breakeven Inflation Rates,” Pu Shen, a senior economist at the Federal Reserve Bank of Kansas City, writes that attributing changes in yield spreads to changes in market inflation expectations and ignoring the liquidity risk premium could lead to erroneous inferences of inflation expectations. The liquidity risk premium in the inflation indexed Treasury securities is an important component of the yield spread. Shen writes that, in all likelihood, from 1999 to 2003 the liquidity risk premium was consistently larger than the inflation risk premium. As the market has deepened, the liquidity risk premium has generally declined and is likely to continue to decline, at least for the five-year inflation indexed securities, Shen writes. “Consequently, when evaluating market-expected future inflation risks from the yield spreads, it is important to consider the impact of possible changes in the liquidity risk premium,” the author concludes. The article is featured in the second quarter edition of the Federal Reserve Bank of Kansas City’s Economic Review. The full article, as well as the current and past editions of the Economic Review, are available on the Bank’s web site at www.KansasCityFed.org. ### Return to
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