FRBSF Economic Letter
2005-25; October 3, 2005
Inflation Expectations: How the Market Speaks
The Federal Reserve wants to know what people think—specifically,
the Fed wants to know what people think the future path
of inflation is. One reason is that people's expectations
about inflation influence their behavior in the marketplace,
and that, in turn, has consequences for future inflation.
Being able to forecast future inflation plays a critical
role in the Fed's efforts to meet its mandate of promoting
price stability in the U.S. economy.
Estimates of longer-term inflation expectations have
been available from various surveys for quite some time.
While
useful, these survey estimates suffer a bit from the "talk
is cheap" problem. What one would like, instead, is
evidence that reflects people's "putting their money
where their mouth is." And, indeed, in recent years,
such a source of evidence has emerged, with the introduction
of new financial instruments. These market-based estimates
represent a bet by market participants on the future
course of the economy, usually in terms of certain economic
indicators
or asset prices, and they have been shown to be better
predictors than survey-based estimates.
One of these new financial instruments is the Treasury
Inflation-Protected Security, or TIPS, which was introduced
by the U.S. Department of Treasury in 1997 as a new
class of government debt obligation. The key feature of
TIPS
is that the payments to investors adjust automatically
to compensate for the actual change in the Consumer
Price Index (CPI). Conventional Treasury securities, in
contrast,
do not provide such protection, so investors in those
securities protect themselves by demanding nominal
interest rates
that compensate them for expected inflation as well
as for bearing the risk that actual inflation could turn
out to differ from their expectations. In principle,
having
information from both types of Treasury securities
allows
researchers to separate out the inflation compensation
component embedded in nominal interest rates.
This Economic Letter discusses the structure of TIPS
contracts, the development of the market in recent
years, and the
measure of inflation compensation derived from comparing
TIPS yields to nominal yields.
How TIPS work
TIPS are one of two types of inflation-protected securities
sold by the U.S. Treasury (the other type is Series I savings
bonds for small investors). In 1997, the Treasury Department
started issuing TIPS that are structured along the lines
of the Real Return Bonds issued by the government of Canada.
Like conventional Treasury notes and bonds, TIPS make interest
payments every six months and a payment of principal when
the securities mature. However, unlike conventional Treasury
notes and bonds, both the semiannual interest payments
and the final redemption payments of TIPS are tied to inflation.
All TIPS are issued by the Treasury using the single-price
auction—the same auction used for all of Treasury's
marketable securities. The interest rate on TIPS, which
is set at
auction, remains fixed throughout the term of the security.
To protect against inflation, the Treasury adjusts the
principal value of the TIPS using the CPI, published
by the Bureau of Labor Statistics. Thus, TIPS are redeemed
at maturity at their inflation-adjusted principal or
their
original par value, whichever is greater. While TIPS
pay a fixed rate of interest that is determined at the
initial
auction, this rate is applied not to the par value of
the security but to the inflation-adjusted principal. So,
if
inflation rises throughout the term of the security,
every interest payment will be greater than the previous
one.
To the extent that both the semiannual interest payments
and the final redemption value of TIPS rise and fall
with the CPI, the nominal return on TIPS hedges perfectly
against
inflation.
The market for TIPS has grown steadily and now includes
three terms to maturity: 5 years, 10 years, and 20
years. The Treasury auctions 5-year and 20-year TIPS semiannually
and 10-year TIPS quarterly. As of 2005, there are about
$200 billion TIPS outstanding, as part of the total
$4
trillion Treasury marketable securities outstanding.
The trading volume of TIPS also has increased gradually
but
still remains small compared to other Treasury securities;
hence, TIPS generally are not as liquid as comparable
Treasuries.
Extracting implied inflation
expectations from TIPS
In principle, comparing the yields between conventional
Treasury securities and TIPS can provide a useful measure
of the market's expectation of future CPI inflation. At
a basic level, the yield-to-maturity on a conventional
Treasury bond that pays its holder a fixed nominal coupon
and principal must compensate the investor for future inflation.
Thus, this nominal yield includes two components: the real
rate of interest and the inflation compensation over the
maturity horizon of the bond. For TIPS, the coupons and
principal rise and fall with the CPI, so the yield includes
only the real rate of interest. Therefore, the difference,
roughly speaking, between the two yields reflects the inflation
compensation over that maturity horizon.
 This
inflation compensation is sometimes referred to as the
breakeven inflation rate because, if future inflation
were at this rate, the realized returns of holding a
conventional
Treasury bond and TIPS would be exactly the same. Figure
1 charts the breakeven inflation rate over the next five
years by comparing the yield on the 5-year Treasury note
to the yield on 5-year TIPS, and the breakeven inflation
rate over the next ten years by using the 10-year Treasury
note and 10-year TIPS, from 1998 to present.
There are two important caveats in using the breakeven
inflation rate to measure inflation expectations. First,
the breakeven inflation rate actually measures the
compensation that conventional Treasury bondholders receive
for expected
inflation and for bearing the risk that realized inflation
may deviate from expected inflation. The breakeven
inflation rate hence has two components: expected inflation
and
the inflation risk premium. Ideally, one would like
to subtract
the inflation risk premium from the breakeven inflation
rate to obtain a pure measure of inflation expectations.
Nevertheless, assuming the inflation risk premium to
be fairly stable over a short period of time, the changes
in the breakeven inflation rate capture the changes
in inflation expectations.
Second, TIPS yields contain a liquidity premium. While
the market for TIPS is growing, it is still relatively
small compared to the market for conventional Treasuries.
Therefore, to the extent that TIPS are less liquid
than Treasuries, investors would demand a liquidity
premium
for holding TIPS over conventional Treasuries. Because
the breakeven inflation rate is obtained by comparing
the yields on TIPS and similar maturity conventional
Treasury
bonds, the breakeven rate captures not only the inflation
compensation but also the liquidity premium demanded
by TIPS investors. In Figure 1, it is quite clear
that the
breakeven inflation rates exhibit an upward trend.
This probably reflects artificially low breakeven
rates when
TIPS were introduced. At that time, the amount of
TIPS outstanding was small and the investor base for TIPS
was narrow, so TIPS were not very liquid and their
yields likely
contained a relatively large liquidity premium to
compensate
investors for holding TIPS in their portfolio. As
the TIPS market has grown, the liquidity premium in TIPS
has shrunk,
resulting in higher breakeven inflation rates.
Interpretations
 The breakeven inflation rate overstates inflation expectations
because of the inflation risk premium in Treasury yields,
but it understates inflation compensation because of the
liquidity premium in TIPS yields. With a more mature TIPS
market, and over relatively short time periods, both the
inflation risk premium and the liquidity premium are likely
to be fairly constant. Thus, the changes in breakeven inflation
rates can be interpreted as the market measure of changes
in inflation expectations. Estimates of intermediate-term
inflation expectations can be extracted using 5-year TIPS
and conventional Treasury securities. To focus on a relatively
short recent time period, Figure 2 shows the 5-year breakeven
inflation rate since July 2004. Note that this measure
of inflation expectations over the next five years has
fluctuated between 2% and 3% over the past 12 months. In
part, the swings reflect temporary factors, such as movements
in energy prices, cyclical factors, and the influences
of monetary policy.
Estimates of longer-term inflation expectations can be
derived using the forward nominal yields and forward
real bond yields. For example, suppose one is interested
in
inflation expectations for the period from 2010-2015,
that is a five-year period beginning five years from now.
The
forward nominal yield for that period is implied by the
5-year and 10-year nominal yield. The forward real yield
is, likewise, implied by the 5-year and 10-year TIPS
yield. And comparing the forward nominal yield to the forward
TIPS yield implies a forward breakeven inflation rate.
Figure 2 plots the 5-year forward 5-year breakeven inflation
rate. It suggests that longer-term inflation expectations
have been trending down from about 3% to about 2.5%
since the beginning of the current monetary policy tightening
cycle. Compared to the spot 5-year forward breakeven
rate, it is noteworthy that the forward breakeven inflation
rate
is more stable. This is because longer-term inflation
expectations tend to be less affected by cyclical factors.
One interpretation of this measure of longer-term inflation
expectations is that it captures the market's assessment
of how well the Federal Reserve promotes price stability
in the long run. From that perspective, the decline
in this measure—by more than one-half a percentage
point
over the last 12 months, despite rapidly rising energy
prices—suggests that the market views the run-up
in energy prices as transitory and that it is confident
in the Fed's
commitment to promoting longer-term price stability.
Conclusions
Given the Federal Reserve's dual mandates, promoting maximum
sustainable output and employment and promoting price stability,
having credibility in fighting inflation gives the central
bank more room to promote economic growth. For example,
with longer-term inflation expectations currently seemingly
well anchored, the recent run-up in energy prices has not
led to widespread fears about future inflation; therefore,
the Fed has not had to tighten more aggressively. Nonetheless,
the Fed cannot be complacent—the credibility of its commitment
to price stability was earned through years of consistent
performance, and to maintain that credibility, the Fed
will need to continue to earn it. And to gauge its success,
the Fed will also continue to pay close attention to longer-term
inflation expectations.
Simon Kwan
Vice President
Opinions expressed in this newsletter
do not necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco or of the
Board of Governors of the Federal Reserve System. Comments?
Questions? Contact
us via e-mail or write us at:
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120
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