Vasilis Dedes ESSAYS ON MONETARY POLICY AND INFLATION MARKETS

Vasilis Dedes ESSAYS ON MONETARY POLICY AND INFLATION MARKETS

ISBN 978-91-7731-107-2 DOCTORAL DISSERTATION IN FINANCE STOCKHOLM SCHOOL OF ECONOMICS, SWEDEN 2018

Essays on Monetary Policy and Inflation Markets Vasilis Dedes Akademisk avhandling som för avläggande av ekonomie doktorsexamen vid Handelshögskolan i Stockholm framläggs för offentlig granskning fredagen den 7 december 2018, kl 15.15, Swedish House of Finance, Drottninggatan 98, Stockholm

Essays on Monetary Policy and Inflation Markets

Essays on Monetary Policy and Inflation Markets Vasilis Dedes

Dissertation for the Degree of Doctor of Philosophy, PhD, in Finance Stockholm School of Economics, 2018 Essays on Monetary Policy and Inflation Markets c SSE and Vasilis Dedes, 2018 Front cover illustration: c i am way /Shutterstock.com, 2018 ISBN 978-91-7731-107-2 (printed) ISBN 978-91-7731-108-9 (pdf) This book was typeset by the author using L A TEX. Printed by: BrandFactory, Gothenburg, 2018 Keywords: Monetary policy, inflation risk premia, term structure, zero bound, quantitative easing, inflation compensation, inflation expectations, break-even inflation, inflation swaps, principal component analysis, reduced rank regression, predictability.

To my parents, John and Rita, and my brother, George

Foreword This volume is the result of a research project carried out at the Department of Finance at the Stockholm School of Economics (SSE). This volume is submitted as a doctoral thesis at SSE. In keeping with the policies of SSE, the author has been entirely free to conduct and present his research in the manner of his choosing as an expression of his own ideas. SSE is grateful for the financial support provided by the Jan Wallander and Tom Hedelius Foundation, and the Swedish Bank Research Foundation (BFI), which has made it possible to carry out the project. Göran Lindqvist Director of Research Stockholm School of Economics Magnus Dahlquist Professor and Head of the Department of Finance Stockholm School of Economics

Acknowledgements This thesis is a result of a team effort. During my PhD journey a large number of people contributed to its completion. First, I want to thank my advisor Magnus Dahlquist. Magnus has been a colleague, a teacher, a friend, and a mentor. His contributions of time, ideas, and funding made my PhD experience productive and stimulating. Magnus gave me the opportunity to collaborate in several research projects and teaching. The skills I learned from him are invaluable. His motivation and inspiration helped me during tough times in the PhD pursuit. I am particularly grateful for his advice on my academic career, but most importantly, for his advice on making life decisions. I am also grateful to Roméo Tédongap who was my advisor in the beginning of my PhD studies. I thank him for introducing me to inflation markets and the fascinating concept of money illusion, and teaching me how to conduct empirical research. I still have hundreds of photos of equations written in almost every single whiteboard at the Swedish House of Finance. I am thankful for his contribution as a coauthor in one of my papers and help with the other papers. I am indebted to Thomas Björk for teaching me stochastic calculus and all the inspirational discussions, Michael Halling for motivation and support, and Irina Zviadadze for helpful comments on my PhD thesis. I also have to gratefully but sadly mention Dave Backus for providing an inspiration to study the interaction between monetary policy and asset prices. Dave was a gifted academic. It was an honor to meet him and a privilege to invite me to visit him at New York University. I would like to thank the faculty and staff at the Swedish House of Finance for providing a perfect research environment. I want to thank my fellow PhD students, especially Xingyu Zhu for her important contribution as a coauthor in one of my papers, Johannes Breckenfelder for providing guidance in the early days, and Laszlo Sajtos. I also thank my friend George Bliatsios.

x ESSAYS ON MONETARY POLICY AND INFLATION MARKETS Lastly, I would like to thank my family for all their love and encouragement. I thank my parents who allowed me to dream and supported me in all my pursuits, and my brother for his friendship and for constantly reminding me that being happy is what really matters in life. Thank you. Stockholm, December 7, 2018 Vasilis Dedes

Contents Introduction 1 1 The economic value of TIPS arbitrage mispricing 3 1 Introduction................................. 4 2 TIPS arbitrage mispricing.......................... 6 2.1 Break-even inflation........................ 6 2.2 Inflation swaps........................... 7 2.3 Arbitrage.............................. 8 3 Data..................................... 9 4 The term structure of TIPS arbitrage mispricing............. 12 5 TIPS arbitrage mispricing and financial volatility............. 14 6 TIPS arbitrage mispricing and asset risk premia.............. 17 7 Conclusion................................. 19 Bibliography................................... 21 Tables and Figures................................. 26 1.A Cook-Setodji Test.............................. 39 1.B Reduced Rank Regression......................... 39 2 Monetary policy and inflation compensation 41 1 Introduction................................. 41 2 Market-based measures of inflation compensation............. 46 2.1 Break-even inflation........................ 46 2.2 Inflation swaps and TIPS arbitrage mispricing........... 47 3 Evidence................................... 47 3.1 Data................................. 48 xi

3.2 Event study............................. 49 4 Conclusion................................. 54 Bibliography................................... 56 Tables and Figures................................. 57 3 Endogenous inflation and the Taylor rule 65 1 Introduction................................. 65 2 Model.................................... 68 2.1 Recursive preferences and real pricing kernel........... 68 2.2 A Markov-switching model for consumption growth....... 69 2.3 Real term structure of interest rates................ 70 2.4 A forward-looking Taylor rule................... 72 2.5 A Taylor rule at the zero lower bound............... 76 2.6 Nominal term structure of interest rates.............. 77 2.7 Term structure of break-even inflation............... 78 2.8 Inflation risk premia........................ 79 3 Quantitative analysis............................ 81 3.1 Calibration............................. 81 3.2 Quantitative results......................... 84 3.3 Monetary policy experiments................... 86 4 Conclusion................................. 87 Bibliography................................... 89 Tables and Figures................................. 92 3.A Real pricing kernel............................. 105 3.B Unconditional moments.......................... 105

Introduction This doctoral thesis consists of three independent papers in financial economics. In these papers I explore the dynamics of inflation markets and the interaction between the real economy, the nominal economy, and monetary policy. In the first paper, my coauthor and I, study one of the most pervasive arbitrage mispricings documented in Treasury bond markets: the relative mispricing of Treasury Inflation-Protected Securities (TIPS). We find that the term structure of TIPS arbitrage mispricing predicts jointly inflation, and bond and equity excess returns. In the second paper, my coauthor and I, use inflation swap rates and break-even inflation rates to study how the effects of Fed s monetary policy actions transmit to inflation markets. This exercise leads us to a useful byproduct. We find that during the period that the Fed implemented unconventional monetary policy the persistent TIPS arbitrage mispricing dropped significantly and inflation markets improved. In the final paper, I develop a theoretical framework to study the implications of endogenous inflation on the term structures of nominal yields, break-even inflation, inflation expectations, and inflation risk premia. I use this framework to conduct monetary policy experiments and explore the effects of monetary policy stance changes on the dynamics of nominal quantities. The list of papers comprising this thesis is as follows. The economic value of TIPS arbitrage mispricing (joint with Roméo Tédongap) Rational frictionless asset pricing models imply that inflation swap rates and break-even inflation rates with same maturity must be equal. The data, however, suggest a persistent positive difference between these two quantities, which the literature attributes to mispricing of Treasury Inflation-Protected Securities (TIPS). In theory, factors driving TIPS mispricing are not directly observable to the econometrician. To reveal these factors, we analyze the daily term structure of TIPS mispricing and uncover its information content. To assess its economic value, we derive novel high-frequency stylized facts about its 1

2 ESSAYS ON MONETARY POLICY AND INFLATION MARKETS dynamics. We document strong relationships with stock market returns, option-implied volatility and variance risk premium, and an important channel for predicting inflation, bond and equity excess returns, jointly. Monetary policy and inflation compensation (joint with Xingyu Zhu) We use two market-based measures of inflation compensation to explore the transmission mechanism of monetary policy to inflation markets. New information about the Fed s monetary policy stance becomes available on the days of meetings of the Federal Open Market Committee (FOMC) and is reflected in asset prices. We measure the sensitivity of inflation compensation measures to changes in monetary policy and compare its magnitudes across different maturity horizons, and across conventional and unconventional monetary policy regimes. Our analysis reveals that risk premia embedded in inflation compensation are horizon and monetary policy regime dependent. Endogenous inflation and the Taylor rule I explore the term structure of interest rates, inflation expectations, and inflation risk premia in an endogenous inflation economy. I illustrate the implications of such an economy in a macro-finance model in which the Taylor rule shock and consumption growth have Markov-switching dynamics. A calibrated version of the model generates a nearly flat term structure of inflation expectations and an upward-sloping term structure of inflation risk premia. I then use the model to conduct monetary policy experiments and measure the effects of monetary policy changes on the dynamics of nominal quantities in the economy. I find that varying the monetary policy parameters in the Taylor rule has a large effect on both inflation expectations and inflation risk premia. A modified version of the model can capture the zero bound constraint on the short-term interest rate.