Are Market Expectations Of Inflation Really Rising?

A typical market-based measure of expected inflation is the inflation breakeven, calculated by subtracting the TIPS yield from Treasury yield at corresponding maturities. The breakeven spread is shown as the blue line in Figure 1.

Figure 1. Five year inflation breakeven calculated at five year Treasury yield minus five year TIPS yield (blue), five year breakeven adjusted by Kim-Wright term premium (red),  and adjusted by Adrian-Crump-Moench term premium (green), all in %. Source: FRB via FRED, NY Fed, and author’s calculations.

The breakeven series has clearly been on the rise. However, what does this series measure?

For the five year maturity, this spread is:

Where i is the nominal yield, r is the real (TIPS) yield, tp is the term premium due to inflation risk, and lp is the liquidity premium associated with the relative thinness of the TIPS market. Using the Fisherian relationship for nominal and real yields, we find the spread is:

Notice that only if the term premium and the liquidity premium move exactly together (or both are always zero) will the spread equal expected inflation. This point is stressed by Andreasen,  Christensen and Riddell (2020), who show that the adjusted spread better predicts inflation. I don’t have estimates of the liquidity premium for 5 year TIPS, but I do have estimates of the term premium on 5 year Treasurys. The implied inflation rate holding at zero the liquidity premium is shown as red line (using the Fed’s Kim and Wright three factor model of the term premium) and green line (using the NY Fed’s Adrian, Crump and Moench five factor model).

While expected inflation is higher when adjusting for the term premium, the increase in the expected inflation is less: 60 bps (FRB) or 30 bps (NY Fed) vs. 90 bps (unadjusted spread). And the adjusted spread has been declining in the last two weeks (through 3/3).

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Disclosure: None.

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