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.