Real Return Bonds: Monetary Policy Credibility and Short-Term Inflation Forecasting

The difference between the yields on long-term Government of Canada conventional bonds and Real Return Bonds (RRBs), which is commonly referred to as the break-even inflation rate (BEIR), has long held out the potential of providing a unique, real-time, market-based measure of inflation expectations. The worth of the BEIR as a measure of inflation expectations can be examined from two perspectives: its usefulness as a measure of monetary policy credibility and as an aid to forecasting inflation. To ascertain the BEIR's accuracy, the historical experience of this measure was examined in relation to alternative measures of the behaviour of long-run inflation expectations. While the broad trends in the BEIR conform with those of other measures of inflation expectations, the BEIR is more volatile and at times deviates significantly from other measures. The purpose of this article is to consider whether these movements can be attributed to changes in risk premiums and other distortions affecting the BEIR rather than to changes in inflation expectations.