Apart from model-based forecasts and periodic surveys of inflation expectations, inflation-indexed bonds provide central banks an estimate of the likely outturn of inflation. Indexed-bonds are particularly attractive, with the advantage of being available for a wide range of maturities, entirely forward looking, timely and updated every working day.

Assuming that the real yield promised by an inflation indexed bond equals the expected real yield on a conventional bond of a similar maturity, the 'breakeven inflation rate' - difference between the conventional bond's nominal yield and the indexed bond's real yield - roughly equals the expected inflation plus risk premium. With an unchanged inflation risk premium, if conventional bond yields rise and indexed bond yields are unchanged, one can infer that there has been a rise in inflation expectations. If yields on conventional and indexed bonds rise by the same amount, one can infer that real interest rates have risen with no change in expected inflation. Looking at conventional and indexed Treasury bonds with various maturities, one can obtain information about real interest rates and market expectations of inflation over various horizons.

Although useful and quite simple, inflation expectations derived from indexed bonds have some limitations. First, since the breakeven inflation rate includes an (unknown) inflation risk premium, it does not give an estimate of the level of expected inflation per se. Thus, breakeven inflation rates provide an overestimate of the expected inflation. Second, inflation risk premium itself could change over time which further complicates the analysis. Third, the stock of indexed-bonds is typically quite small compared to conventional bonds and hence indexed bonds might also include some liquidity premium. Illustratively, due to a rise in demand for indexed-bonds by various investors such as insurance companies, breakeven inflation rates derived from French government bonds increased in early 2004 without any increase in inflation expectations (Noyer, 2004). Fourth, yields on indexed-bonds are linked to headline inflation whereas monetary policy-makers are more interested in core inflation. This link with headline inflation makes inflation expectations derived from indexed-bonds much more volatile than true expectations. In view of the above factors, the various biases, although small, may add together in a potentially non-systematic way and breakeven inflation rates may, therefore, not be a reliable guide about the expected inflation rate.

In India, one variant of capital indexed bonds (CIBs) (viz., 6 per cent Capital Indexed Bond 2002) was issued for the first time on December 29, 1997. Subsequently, there was no further issuance of CIB mainly due to lack of an enthusiastic response of market participants for the instrument. Taking into account past experience as well as the internationally popular structure of CIBs, a modified structure of CIBs is proposed to be introduced. The proposed CIB would offer inflation-linked returns on both the coupons and principal repayments at maturity. The coupon rate for the bonds would be specified in real terms. Such real coupon rate would be applied to the inflation-adjusted principal to calculate the periodic semi-annual coupon payments. The principal repayment at maturity would be the inflation-adjusted principal amount or its original par value, whichever is greater. There is thus an in-built insurance that at the time of redemption the principal value would not fall below par. The proposed CIB would facilitate measuring the inflation expectations of the market participants and provide a useful input in assessing the inflation conditions in the conduct of monetary policy.

Although in the medium-term, alternative indicators of inflation may show a similar order of variation, year-to-year movements, as noted earlier, in the various measures could differ due to differences in the coverage and weighing scheme. An attempt is, therefore, made to model the behaviour of the three major measures of inflation in India: wholesale price inflation, consumer price inflation and inflation based on GDP deflator. Excess demand in the economy is proxied by output gap defined as actual output less potential output (as percent of potential output). Foodgrains inflation is included in the equation to incorporate supply shocks that could be on account of weather conditions as well as the administered pricing mechanism (procurement prices).