The Real Interest Rate and the Expected Rate of Inflation

This paper presents a method for deriving the real interest rate and the expected rate of inflation from the market information contained in indexed government bonds. It also discusses the implications and potential use for monetary policy of the infor-mation derived about the real interest rate and the expected rate of inflation. In theory, the real interest rate represents the marginal product of capital or the discount rate used in intertemporal market exchanges. Therefore, it acts to signal conditions in the real economy. The expected rate of inflation represents the aver-age expectation of market participants about future inflation. Therefore, it affects the economic decisions of market partici-pants. It contains information about the judgment of market players, which is useful as a leading indicator of the future price level. This paper uses data on U.K. government-indexed bonds. It shows that the derived real interest rate and the expected rate of inflation provide very useful information for monetary policy. This paper also shows that the Fisher equation and the rational expectations hypothesis are incompatible, and that the expected rate of inflation obtained from the Fisher equation is far more stable than the realized rate of inflation and the expected rate of inflation obtained from the rational expectations hypothesis