The inflation protection from indexed bonds

Abstract

Indexed bonds provide protection against inflation if they are (i) insensitive to revisions of inflation expectations but (ii) adjust one-for-one to unexpected inflation. The sensitivity of British index-linked gilts to unexpected inflation is statistically significant and consistent with a unit response. This protection of British index-linked gilts against a loss of contemporaneous purchasing power is consistent with the view that indexed bonds avoid the inflation risk compensation of conventional bonds. This suggests that issuing indexed instead of conventional government bonds reduces the long-run funding costs of the public sector borrowing requirement.