Tuesday, September 9, 2008

Treasury Inflation-Protected Securities and Inflation Expectations

First there was the inflation scare, then there was the deflation scare, and now it seems any network or blog can find enough economists to support either scenario as a grave concern for the economy.

In times of confusion, I like to take my cues from the markets. This time around I am talking about the future inflation rate expectations that can be derived from Treasury Inflation-Protected Securities, more commonly known as TIPS. Using the CPI as an inflationary benchmark, TIPS coupon payments and the underlying principal are automatically adjusted to account for inflation. With a couple of assumptions to mitigate a liquidity premium and inflation-risk premium, a market assessment of inflationary expectations can be derived from the difference in yield between nominal treasury notes and TIPS, which is exactly what the graph below shows.

Based on the TIPS yield differential analysis, it appears as if inflationary expectations peaked in either late February or late June and have been steadily trending lower over the course of the past two months, to the point that current inflationary expectations are at levels not seen in at least ten months.



[source: Federal Reserve Bank of Cleveland]

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