Inflation ambiguity and the term structure of U.S. Government bonds

Variations in trend inflation are the main driver for variations in the nominal yield curve. According to empirical data, investors observe a set of empirical models that could all have generated the time-series for trend inflation. This set has been large and volatile during the 1970s and early 1980s and small during the 1990s. I show that log utility together with Knightian uncertainty about trend inflation can explain the term premium in U.S. Treasury bonds. The equilibrium has two inflation premiums, an inflation risk premium and a Knightian inflation ambiguity premium.

► Knightian ambiguity about inflation explains the positive term spread in U.S. Treasury bonds.
► The equilibrium in the model endogenizes that Treasury bonds pay an inflation ambiguity premium.
► Fear of inflation misspecification increases when realized inflation is higher than expected.
► Long-term Treasury yields are particularly strongly affected by inflation ambiguity.
► The inflation ambiguity premium is time-varying with a sample mean of 1.75% for a long-term bond.