September 20, 2013
This paper shows how purchasing power parity (PPP) can be used to construct a measure for inflation expectations and discusses the properties of this measure from both a theoretical and an empirical perspective. Under the PPP hypothesis, inflation expectations in one country are equal to inflation expectations in another country plus the expected depreciation rate of the nominal exchange rate. Exploiting this formula, we calculate Japanese inflation expectations from the break-even inflation rates (BEI) and FX forward spreads for five countries (United States, United Kingdom, Australia, Canada, and Sweden). The resulting PPP-based measure of inflation expectations follows a trend that largely coincides with long-run developments in the Japanese BEI. However, we find that both levels of and variations in the new measure differ across the reference countries, and that a recent gap between the new measure and the Japanese BEI is not negligible from a short-run perspective. Consequently, there remain several issues that need to be addressed to assess the usefulness of this new formula.
BEI; Foreign exchange forward spread; Inflation expectations; Inflation-indexed bonds; PPP
We are grateful for helpful discussions with and comments from Tomoyoshi Yabu, seminar participants at Hitotsubashi University, and the staff of the Bank of Japan. The views expressed herein are those of the authors alone and do not necessarily reflect those of the Bank of Japan.
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