Some people on Wall Street argue that conventional Treasury bonds are preferred to TIPS, and hence the TIPS spread underestimates actual market inflation expectations. I’m inclined to agree.

The current 5-year TIPS spread is 1.34%, which is based on CPI inflation. That suggests a PCE inflation rate that is barely above 1%, as PCE inflation tends to run at least 0.25% below CPI inflation, and indeed recently the gap has been even larger.

In contrast to this implied 1% PCE inflation forecast, the Fed expects slightly below 2% inflation over 5 years, as does the consensus of private forecasters. I also expect inflation to be only modestly below 2%, which has been the pattern over the past two years.

Of course, we could all be wrong, but what if the TIPS spread is biased?
In that case, how can we derive the actual market forecast of inflation?

You could use a CPI futures market. But if this market were tiny relative to the TIPS market (and I believe it is) then arbitrage would probably force CPI futures prices to correspond to TIPS spreads, even if traders thought the actual inflation rate would be higher. (As an analogy, consider the situation if bond market and currency futures market traders disagreed about the future path of exchange rates. The interest parity condition would still hold approximately true due to arbitrage.

Now for my question. How can a less biased inflation indicator be constructed? For instance, what about creating security that paid $1000 if the 5-year inflation rate ended up being in the 1.4% to 2.6% range, and zero otherwise. My gut instinct is that that outcome is very likely, say over 85% likely. If the market agrees, wouldn’t those contracts sell for at least $500, even if the 5-year TIPS were predicting 1.0% inflation? If so, wouldn’t that prove that inflation expectations are actually well above 1.0%?  I’d certainly pay $500 for that sort of security. Or would arbitragers force any newly created market on inflation expectations to correspond to the implied TIPS prediction, no matter how the new market is designed?

In other words, is there a market design that overcomes the “arbitrage” problem and gets us close to the truth (about people’s expectations), or is this an impossible goal?

Paging Robin Hanson.