It’s Even Worse Than I Thought

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


11 Responses to “It’s Even Worse Than I Thought”

  1. 1 Benjamin Cole September 23, 2011 at 9:07 am

    Really great blogging of late. Japan did you good!


  2. 2 Luis H Arroyo September 23, 2011 at 10:19 am

    Very good and Clear, as usual.


  3. 3 foosion September 23, 2011 at 12:11 pm

    TIPS are less liquid than the corresponding treasuries, so you get a bit of a liquidity discount.


  4. 4 Lars Christensen September 23, 2011 at 2:10 pm

    David I have suggest this rule at Scott’s blog… How about the FOMC announced that it would buy 100bn worth of T-bills in the beginning of every month if the Cleveland fed 5-year inflation expectation is below 2%. One month later if it is still below 2% they step up the buying to 200bn. Every month the Fed doubles the buying until inflation expectations hit 2%. Once inflation expectations hit 2% the Fed suspend the buying of T-bill. This is not exactly NGDP targeting, but in my view this would ensure a very swift recovery in the US economy and I have a hard time seeing how the Republicans could be against such a clear inflation target. I think our friend John Taylor would have to endorse it as well.

    I think the Cleveland inflation expectations numbers provides an excellent guide for monetary policy – the Fed should use the tools developed by their our analysts.


  5. 5 Benjamin Cole September 23, 2011 at 4:08 pm


    You didn’t ask my opinion, but let me stick my nose in a say I like your idea.

    I hate the same idea, but less and more aggressive. I jthink the Fed should buy $100 billion a month until the Cleveland Fed inflationary expectations measure gets to 3 percent, and leave it there for a while perhaps still buying up to 3.5 percent—4 percent for a year or two, and gradually back to 2 percent by selling bonds.

    As we are in a recession after a real estate bust (lots of bad nominal loans and real estate under water), I don’t mind a few years of moderate inflation now. We need to de-leverage real estate debtors, and the federal debt too.


  6. 6 Benjamin Cole September 23, 2011 at 4:09 pm

    Lars–a couple typos there. I have (not hate) the same idea.


  7. 7 Steve September 26, 2011 at 11:35 am


    The WSJ just gave you more material for a blog post. They published an opinion piece saying higher AD didn’t end the Great Depression, ending the gold standard only produced inflation and that it was improved incentives for investing ended the depression. I posted this on Scott’s blog as well.


  8. 9 David Glasner October 2, 2011 at 10:06 am

    Benjamin and Luis, Thanks. I’m not sure that it was Japan, but I did have a pretty good run.

    foosion, You are right about the liquidity effect.

    Lars and Benjamin, I agree with both of you, but in my variant the Fed would set a price level target at least 10% above the current level and then the Fed would try to reach it as fast as possible. Once the target was reached, a new price level target would be set and the target would rise by 2% a year.


  1. 1 Skepticlawyer » A misbegotten Union – Guest post by Lorenzo Trackback on October 5, 2011 at 12:39 am
  2. 2 Yes, Virginia, The Stock Market Really Does Love Inflation « Uneasy Money Trackback on October 27, 2011 at 9:25 pm

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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