PROCEEDINGS May 15, 16, 17, 18, 2005 - Casualty Actuarial Society

MODELING FINANCIAL SCENARIOS 211making their own determination of what to expect regarding futureeconomic conditions, but many other factors, including theirown experience, the counsel of other participants, and recent historicalexperience, are used to determine their inflation expectations.There is no survey of representative market participants todetermine what they truly anticipate for the inflation rate.The second approach has been to examine actual inflationrates that have occurred, and then subtract those from prior interestrates (ex post analysis). This approach is also flawed forseveral reasons. First, there is no reason to believe that the marketis prescient regarding inflation expectations. Especially in thecase of an unexpected shock to the system, such as oil price increasesduring the 1970s, the market does not know what willhappen in the future. It cannot even be assumed that errors inforecasting will cancel out over time, since the market could bebiased to underestimate or overestimate future inflation. Second,actual inflation cannot be accurately measured. The ConsumerPrice Index and other values commonly used to determine inflationare widely recognized as being imperfect. These indicestrack the prices of specific goods and services that are not completelyrepresentative of the entire economy. These indices cannotrecognize the substitution effect in which consumers continuallyengage, such as buying more chicken than usual whenbeef prices rise, or driving less when gasoline prices soar. Due tothese problems, it is not possible to claim that real interest ratescannot be negative, so a small negative value over a short timeinterval does not necessarily represent a problem.On the opposite side of the distribution, the 99th percentilevalue for one-month real interest rates after 10 years is 10%. Thesame limitations described above also apply to this value.Going further out on the term structure, the mean value ofthe one-year real interest rate after the first projection year is0.9%. This reflects reversion from the initial value of 0% tothe long-term mean of 2.8%. The mean of the last value, after50 years, which is in line with these parameters, is 2.9%. The