Sunday, March 09, 2008

Inflation Expectations

This chart is showing up in too many places. The latest, to which I link, is Greg Mankiw's blog.

The implication is that the expected CPI inflation rate over the next ten years has risen from its typical value of around 2.5% to around 3.4% recently. There's little question that the expected inflation rate has risen over the past couple of months, with commodity prices rallying like never before (literally), and that is certainly an issue that the Fed has to be concerned about, but do we really believe that the expected inflation rate has risen quite so dramatically?

I don't. If you look at the raw breakeven inflation rate from the 10-year tips-to-nominals spread, it has only risen by about 20 basis points in the past couple of months, and it still hasn't taken out the highs that it made in 2005 and 2006. We can reasonably surmise that this understates the increase in expected inflation, since we also know that liquidity has gone to a premium over the past 6 months and that TIPS are less liquid than nominal Treasury notes. We can't quite be sure, though, because inflation uncertainty has also increased, so the increased risk premium for inflation uncertainty (which applies to nominal Treasuries) may be offsetting the increased liquidity premium (which applies to TIPS).

The 3.4 percent figure comes from a very specific way of estimating the liquidity premium. IIRC the Cleveland Fed does a regression on the spread between on-the-run (recently auctioned and therefore highly liquid) and off-the-run (slightly less liquid) Treasury notes. Recently that spread has increased dramatically, so the methodology is adding a large liquidity premium onto the expected inflation rate. But how large, exactly, should it be? Given that liquidity conditions are outside the range of the data prior to August 2007, and given that I think there are omitted variables (specifically, a time trend over the period during which TIPS were becoming more available and gaining more market acceptance, as well as a reverse time trend at the very beginning, when TIPS were new and exciting and therefore didn't need to offer high yields) in the specification, and given that I'm not sure that the on-the-run-to-off-the-run spread is the best measure of the liquidity premium anyhow, and given that there are issues about the inflation risk premium, I'm not at all comfortable accepting the Cleveland Fed's estimate.

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20 Comments:

Blogger Ken Houghton said...

I bought TIPS (for my daughter) in 2006, and haven't really considered doing it again.

If you look at the UM sentiment numbers at the Cleveland Fed, you'll see that reported inflation expectations are largely consistent in the past several years—and higher than the TIPS rates.

Mankiw is asking the wrong question; why doesn't the TIPS market reflect actual expectations would lead him in the correct direction, back to a supply-demand-insurance-protection model that is returning to rationality.

Tue Mar 11, 11:41:00 AM EDT  
Blogger Ivan Kitov said...

Short-term fluctuations are the worst basis for prediction of long-term trends. One should bear in mind the ongoing discussion on the difference between headline and core CPI (PCE).
http://inflationusa.blogspot.com/search/label/core%20CPI

The link between labor force growth and inflation unambiguously indicates that deflationary period is a more likely scenario for the next ten years. According to this link, the end of 2007 and the beginning of 2008 are characterized by the highest inflation, as was predicted two years ago:
http://inflationusa.blogspot.com/search/label/deflation

Thu Mar 13, 06:17:00 AM EDT  
Blogger Ivan Kitov said...

Well, what will economists say now (9:00 14.03.2008) with February CPI and core CPI around zero?
Look out! Deflation is coming!

Fri Mar 14, 08:53:00 AM EDT  
Blogger Francisco said...

knzn:
What do you think of Brian Sack's method to estimate inflation expectations?

Basically, he constructs a portfolio of STRIPS with the same liquidity and duration as the inflation-indexed security, and estimates inflation expectations from there. (See title and abstract of his paper below.)

His method takes care of the liquidity risk premium, but not of the inflation risk premium. Still, it looks much better than the Cleveland's method.

What do you think?

Title: Deriving Inflation Expectations from Nominal and Inflation-Indexed Treasury Yields

Abstract:
This paper derives a measure of inflation compensation from the yields of a Treasury
inflation-indexed security and a portfolio of STRIPS that has similar liquidity and
duration as the indexed security. This measure can be used as a proxy for inflation
expectations if the inflation risk premium is small. The calculated measure suggests
that the rate of inflation expected over the next ten years fell from just under 3% in
mid-1997 to just under 1 ¾% by early 1999, before rising back to about 2 ½% by the
beginning of 2000. This variation is more extensive than would have been expected
from a simple model of inflation dynamics or from a survey measure of long-run
inflation expectations.

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