Why Do They Follow Each Other? The Highly Correlated Nominal and Inflation-Protected Rates of Interest

Recently, the correlation between the inflation-protected and the nominal rates of interest has increased, whereas the correlation between the corresponding holding rates of return has remained insignificant. The conventional view, however, is that to the extent that changes in the nominal rate are due to changes in expected inflation, the real rate should be orthogonal to the nominal rate. This article establishes an algorithm, founded upon the absence of arbitrage opportunities, demonstrating that biased forward prices in the corresponding markets are related to the instantaneous sensitivity of the inflation-protected rate of interest to the nominal rate, which may explain the high correlation between the two. This hypothesis is empirically validated with a relatively high explanatory power in most subperiods of the sample. This result implies a new related angle to the notion of inflation risk premium.