The gilts market as an 'on-line window' on expected inflation
It is argued that government policy could be greatly improved by the existence of a gilts market 'window' on expected inflation. The indexed gilts method for measuring expected inflation, developed by Levin and Copeland (1993), is described and extended. This extended method is applied to the 41 market days between 20 August 1992 and 15 October 1992 in order to observe how the developing crisis associated with Britain's departure from the European Exchange Rate Mechanism affected real interest rates, expected inflation and the inflation uncertainty premium. The estimates for this period demonstrate that it is technically possible with the indexed gilts method to 'read' the financial markets' forecast of the future path of inflation in the UK. In addition, the estimates show quite clearly that the expected inflation path alters in response to external shocks and to subsequent policy reactions.