U.S. Economy
Are Inflation Expectations on the Rise?
Deciphering Signals from the Bond Market

Evan F. Koenig looks at how bond yields measure up as a guide to inflation expectations and monetary policy.

A Difference of Opinion
Long-term interest rates have drifted upward in recent months, despite cuts in the Fed’s short-term interest rate target (Chart 1). Some commentators argue that this lack of response signals that bond investors’ long-term inflation expectations are on the rise and, hence, that the Fed may have eased too much. Other commentators take just the opposite tack. They cite stubbornly high long-term interest rates as evidence that cuts in short-term interest rates aren’t providing the desired stimulus to the economy and that the Fed needs to do more.

Chart 1

Complicating the debate is the fact that long-term interest rates can move, or fail to move, for a variety of reasons. While an increase in expected inflation will lead bond investors to demand higher yields, so, too, will concerns about the potential for future tax rate increases (in particular, increases in the tax rates applicable to interest income) or an improvement in real growth prospects. In addition, a more uncertain economic environment is generally thought to put upward pressure on long-term yields relative to short-term yields.

To isolate the effects of higher inflation expectations on bond yields, it is tempting to turn to the market for Treasury inflation-indexed securities (TIIS)—government bonds that guarantee investors a certain rate of return after inflation if held to maturity. TIIS yields are affected by changes in future growth prospects in the same way as conventional-bond yields, and their tax treatment is also fairly similar. Provided yields on conventional and TIIS bonds react similarly to changes in uncertainty, the difference between their yields (the "TIIS spread") ought to be a valid measure of investors’ inflation expectations. With this in mind, it’s worrisome that TIIS spreads have recently widened. The TIIS spread for bonds with a 7.5-year maturity, for example, increased from 1.7 percent to 2.1 percent earlier this year (Chart 2). These TIIS-spread increases would seem to support the view that the Fed has eased too much.

Chart 2

Complications
Properly interpreting TIIS spreads turns out to be not quite so simple. For evidence that there is a problem, contrast inflation expectations as measured by the 7.5-year TIIS spread with five- to 10-year inflation expectations as measured by the University of Michigan’s survey of consumers (Chart 3). The Michigan survey shows a decline in long-term inflation expectations from 3 percent in third quarter 1997 to 2.7 percent in third quarter 1998 and then a very gradual increase back to 3 percent. The inflation expectations implicit in the TIIS spread are lower and much more volatile. The two series clearly tell very different stories. Why? Which story is to be believed?

Chart 3

A strong case can be made that one should put greater credence on the survey results. As noted above, the TIIS spread is a useful measure of inflation expectations only insofar as the yields on TIIS and conventional bonds respond similarly to changes in economic uncertainty. Unfortunately, a similar response is unlikely in at least two cases. First, TIIS and conventional bond yields are unlikely to respond similarly to a change in inflation uncertainty. Households are willing to pay an insurance premium (sacrifice some yield) to reduce the chances that inflation will erode the purchasing power of their savings. The greater the inflation uncertainty, the lower the yield at which TIIS are an attractive alternative to conventional bonds. Thus, high inflation uncertainty can mimic the effects of high expected inflation by lowering the yield on TIIS relative to that on conventional bonds. In times of financial crisis, in contrast, the yield on TIIS is likely to rise relative to that on conventional bonds, mimicking the effects of low expected inflation. This is because in times of financial crisis investors seek assets that are at the same time safe and liquid (readily bought and sold). TIIS are certainly every bit as safe as conventional government bonds, but a relatively low transactions volume means that they are not as liquid. It is not surprising, therefore, that the TIIS spread fell sharply in the third and fourth quarters of 1998, when the Russian debt default and the near-collapse of the Long-Term Capital Management hedge fund caused money to flood into the conventional Treasury market.

To test the importance of inflation uncertainty and the demand for liquidity for understanding movements in the TIIS spread, I used the dispersion in professional forecasters’ long-term inflation expectations as a measure of inflation uncertainty and the difference between the yields on high-quality corporate and conventional Treasury bonds as a measure of the demand for liquidity. (Like the TIIS market, the market for corporate debt is illiquid relative to that for conventional Treasury bonds.) I found that these two variables explain about half of the variation in the difference between the Michigan measure of inflation expectations and the TIIS spread. Each variable is statistically significant and has the expected sign.

The line labeled "Adjusted TIIS" in Chart 4 shows the inflation expectations implicit in Treasury yields after adjusting for changes in inflation uncertainty and the liquidity premium. The adjusted TIIS-spread series remains somewhat more volatile than inflation expectations as measured by the University of Michigan but now displays a qualitatively similar pattern. Thus, inflation expectations fall from 3.5 percent to 2.3 percent during the first third of the sample and then gradually increase to 3.2 percent. Possibly, results would be even more similar to the Michigan survey if better measures of inflation uncertainty and the liquidity premium were available.

Chart 4

Conclusion
TIIS spreads are not a very good guide to inflation expectations because they are sensitive to changes in inflation uncertainty and the demand for liquidity. In particular, the recent increase in TIIS spreads probably overstates the extent to which investors’ long-term inflation expectations have risen. It should not carry much weight as evidence for the proposition that the Fed has eased too much in response to the current economic slowdown.

About EYI | Global Economy | U.S. Economy | Regional Economy | Free Enterprise | Money & Banking | Technology
Federal Reserve Bank of Dallas | FRB Dallas Publications