Inflation Expectations, Post-Passage Of The American Rescue Plan

At the end of the week, the five year constant maturity Treasury yield continued to rise along with the implied expected inflation rate; but after accounting for the estimated term premium and liquidity premium (h/t Bob), the increase in the latter since the Georgia elections is much more modest.

Figure 1. Five year inflation breakeven calculated as five year Treasury yield minus five year TIPS yield (blue), five year breakeven adjusted by term premium and liquidity premium per DKW, all in %. Source: FRB via FRED, DWW following D’amico, Kim and Wei (DKW), and author’s calculations.

The unadjusted 5 year Treasury-TIPS spread is:

Where tp is the term premium on the Treasury yield, and the lp is the liquidity premium on the TIPS yield. Using the DKW estimates of the Treasury term and TIPS liquidity premia as reported by Kim, Walsh and Wei (2019, data 2021), one obtains the following estimates of expected inflation show as the red line above.

As of 2/26/2021, the unadjusted series is 0.58 percentage points higher than the adjusted; that is the expected inflation rate over the next 5 years is 1.8% instead of 2.4%. If the gap between the two premia has remained constant (no reason that would be true), then expected inflation remains below 2%.

Disclosure: None.

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