Bond futures, inflation-indexed bonds, and inflation risk premium

•A new approach is proposed to measuring long-run inflation risk and expectations.•Bond futures information is added to the information set, and inflation risk is an incremental covariance.•Focusing on the UK for 1985–2012, the average risk premium is 87 basis points.•The derived inflation expectations suggest that credibility has improved.•Inflation targeting policy has anchored long-run expectations.

We propose a new approach to measuring long-run inflation risk, the inflation risk premium, and inflation expectations for the UK over the period 1985–2012. By adding long-term bond futures to the information set of inflation-indexed and nominal bonds, inflation risk is measured as an incremental time-varying covariance obtained from a trivariate GARCH model with dynamic conditional correlations (DCC). The time-varying inflation risk premium and inflation expectations are extracted from the breakeven yield using the risk premium obtained from the previous step. We find that the risk premium has been decreasing over the sample period, with an average value of 87 basis points. The estimated long-run inflation expectations suggest that credibility has been improving over the period of inflation targeting policy, and are in line with the role of inflation targeting policy in anchoring expectations.