An alternative automatic indexing model and an empirical investigation into the relationship between nominal interest rates and expected inflation

Abstract

The purpose of this research study is to theoretically examine the joint issue of horizontal and vertical tax equity and automatic indexation when classes of assets do not equally respond to inflation. As part of this analysis, two indexing strategies were introduced: full indexing and unequal indexing. Full indexing adjusts income by an amount equal to the inflation of the period; whereas, unequal indexing adjusts income by an amount equal to the unanticipated inflation reflected in a class of assets. An overall conclusion of the theoretical analysis is that unequal indexing is "fairer" than full indexing. Yet the adoption of unequal indexing would require a measure of expected inflation in order to categorize classes of assets into homogeneous stratum. Expected inflation, however, is not directly observable. One measure of expected inflation that has been suggested is the Interest Rate Index. To test this assertion, this study has empirically examined the question that yields of auctioned 91-day U.S. Treasury Bills fully reflect expected inflation as measured by a two-step ahead forecast of the Gross National Product-Implicit Price Deflator. The conclusion reached was that the yields reflected less than expected inflation for the period of 1959I through 1980III at a 5% level of significance. Hence, if the Interest Rate Index were constructed from these yields, then it too would reflect less than expected inflation as measured by the Implicit Price Deflator.