Inflation Ambiguity and the Term Structure of Arbitrage-Free U.S. Government Bonds

Inflation plays a very important role in the pricing of nominal bonds. Investors care not only about inflation shocks, but also how the volatility of inflation shocks may change over time. While inflation volatility was low for most of the 1970s and 1990–2003, it spiked in the early 1980s. This paper specifies and estimates a three-factor model for the nominal term structure which accounts for two sources of inflation premia. The first premium is determined by the product of risk aversion and the covariance between inflation and consumption. The second premium is determined by the product of model uncertainty aversion and the volatility of inflation. The second premium arises because the investor is uncertain about the true statistical distribution of future inflation. This premium was high in the early 1980's and it subsequently decreased the post-1980 term premium.