November 1, 2003
Yield spreads between rates on Treasury nominal and inflation-indexed securities are thought to be distorted measures of expected inflation because of various biases. Three sources of bias are investigated in this paper: risk aversion, inflation uncertainty, and failure to account for the explicit option on the redemption value of the Treasury’s inflation-indexed security when there is a probability of deflation. The analysis produces estimates of all three biases. It finds that significant bias could arise from the second and third sources, while any bias from the first source appears negligible.