The Cleveland Fed recently released its estimates of inflation expectations. The simple (I hope not simplistic) way to infer inflation expectations is to calculate the breakeven rate between the yield on a conventional Treasury for a given duration and the yield on the corresponding TIPS for the same duration. Thus, for the 10-year Treasury, the yield yesterday was 1.72% and the yield on the 10-year TIPS was .01%, so the implied inflation expectation was 1.71%.
However, economists at the Cleveland Fed figured out that this calculation ignores what they call the inflation-risk premium. In other words, when you form an expectation of what the future inflation is going to be, you also have some notion of how confident you are that your expectation will turn out to be on target. You also have a notion of how upset you will be if it turns out that your expectation is off the mark. Your uncertainty about your expectation and your tolerance for being wrong about your expectation together determine the inflation-risk premium. The TIPS-spread reflects both expected inflation and the inflation-risk premium. The Cleveland economists have developed methods for estimating the inflation-risk premium, potentially allowing them to estimate the implied market expectation of inflation more accurately than by just calculating the breakeven TIPS spread.
Every month, coinciding with the release of the CPI for the previous month, the Cleveland Fed releases its estimates of real interest rates for various durations, the expected rate of inflation for corresponding durations, and the inflation risk premium. So for the 10-year duration that I generally use as a benchmark, the Cleveland Fed estimated the implied inflation expectation on September 1 to be only 1.37%, down form 1.98% in April and 1.56% in August. Since September 1, the breakeven TIPS spread on the 10-year Treasury has fallen 37 basis points.
If half of that fall reflects falling inflation expectations, then inflation expectations over a 10-year time horizon may be approaching 1.2%. With real interest close to being negative, inflation expectations that low should be setting off alarm bells. Let’s hope somebody is listening.
HT: Lars Christensen