Inflation Expectations: How The Market Speaks
Interesting interpretation of how inflation rates work and how to protect yourself.
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Pre Introduction (Via San Fran Fed)
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.
Article Introduction (Via San Fran Fed)
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.
Topics Covered (Via San Fran Fed)
1. How Tips Work
2. Extracting implied inflation expectations from TIPS
3. Inflation Interpretations
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