Inflation Expectations

A subscriber recently wrote in to ask why the current interest rate spread between Treasury Inflation Protected Securities (TIPS) and standard Treasuries seems to imply a much lower rate of expected inflation over the next few years (around 2%) than we have been forecasting (up to 7%).  The common assumption is that this interest rate spread corresponds to market inflation expectations, but we do not hold to this view.  

The TIPS – Treasury spread is not a very reliable indicator of inflation expectations for a few reasons.  For one thing, in order for the spread to really be reliable the two securities would have to be identical in every regard other than the inflation indexing offered on TIPS.  This isn’t really the case because the market for TIPS is so much smaller than for standard Treasuries, about 1/5 to ¼ the size, so there’s a substantial liquidity premium on TIPS yields.  This narrows the spread, which means that it understates inflation expectations.  

The Kansas City Fed put out a good research article on this and other factors, and finds that the TIPS spread understates expected inflation relative to both historical inflation rates and estimates based on surveys of economists’ forecasts.  This is especially the case during periods of financial stress and crisis.  So the popular assumption that this spread provides a good indicator of inflation expectations is not valid.