Inflation Expectations and Monetary Policy
Recently, there has been what many observers consider to be a disturbing increase in the yield curve. The concern is that the rising yield curve may be signaling an increase in longer-term inflation expectations. In normal times, the sort of increase we have seen in the yield curve would not garner much attention, but two developments have already aroused speculation about possible substantial increases in future inflation. One is the huge expansion of the Fed's balance sheet, and the other is the Fed's purchases of long-term treasury securities and mortgaged-backed securities. These purchases have many worried that the central bank could suffer significant capital losses on its portfolio, which would make it difficult to unwind the portfolio's expansion.
To understand why the increase in the yield curve may be troubling, it is helpful to remember that the yield curve can be used to back out implied expected forward rates. That is, a steep yield curve implies that interest rates are expected to increase. For example, the implied 5 - 10 year forward rate for nominal bonds measures what the average interest rate on nominal bonds is expected to be 5 - 10 years out. Increases in these forward rates are thought to be governed largely by future increases in the real interest rate or future increases in inflation.
One way to gauge whether it is inflation or interest rates that is driving the recent increase in the yield curve is to look at information contained in inflation-adjusted treasury securities (TIPS). TIPS can be used to estimate the implied 5 - 10 year forward rates for real interest rates or to back out the "breakeven" inflation rate, which is frequently used as a measure of expected inflation. When we look at TIPS-estimated interest rates, we see no increase in implied forward real interest rates, suggesting that future real rates are not driving the recent increase in the yield curve.
Meanwhile, breakeven inflation has crept up for 2, 5, 7, 10, and 20 years out. In times of serious liquidity concerns, however, interpreting the TIPS breakeven inflation measure is problematic. TIPS securities are less liquid than regular nominal securities, a fact that lowers their price and increases their yield. Shifts in liquidity pressures will therefore affect measured expected inflation (as liquidity pressures increase, expected inflation appears to decrease, and vice versa).
Because most measures of liquidity concerns have decreased since the last FOMC meeting, some analysts have concluded that the observed increase in expected inflation is illusory and is driven instead by the observed decline in liquidity pressures. Similarly, decreases in breakeven inflation before that were probably due to increases in liquidity pressures. But assuming the liquidity pressures on 5-year TIPS are similar to those on 10-year TIPS, the implied 5 - 10-year breakeven inflation rate is probably the best measure we have of long-term inflation expectations. Looking at this measure suggests that long-term inflation may have increased 30 basis points since the April FOMC meeting, and nearly 2 percentage points since the end of 2008. But it needs emphasizing that despite the sharp increase in the rate of expected inflation, the rate is still slightly lower than it was in mid-2008.
This bias, however, will influence shorter-term, 5-year TIPS more heavily than longer-term 10-year TIPS. Thus, during periods of significant deflationary risk, 5-year breakeven inflation will be greater than actual expected inflation, and since the 10-year TIPS is not as heavily affected by this, the 5 - 10 year forward rate will underestimate expected inflation. This suggests that part of the large decrease in this measure registered during 2008 was reflecting the short-term deflationary risk facing the economy. Now that the economy appears to be recovering, this deflationary risk is fading, and the 5 - 10 year forward breakeven inflation rates are increasing and probably, once again, coming closer to truly representing long-term inflation expectations.
But this bias in TIPS has led many to discount the fact that real yields as measured by TIPS have not been increasing. They argue that the recent run-up in the yield curve suggests that a recovering economy is indicative that future real interest rates are increasing (stronger future economic growth pushes up future real interest rates). Proponents of this view point to yield spreads, like the difference between 10-year and 5-year treasury yields, to bolster their case that increases like those we have seen are normal when the economy starts recovering. But the 5 - 10 year forward rates, which directly measure what rates are expected to be 5-10 years out show little in the way of a clear cyclical pattern.
To pursue this question further, we look at the behavior of the 5 - 10 year out "normalized" yield curve (where the initial 5 - 10 year forward rate is normalized to one) over this and past business cycles. While the yield spread typically increases when the economy is expected to recover, forward rates do not appear to have ticked up noticeably at this point in the recession - 18 months after it started. Furthermore, the increase we have seen in forward rates comes on the heels of much larger decreases than in past recessions.
It is certainly too soon to conclude that long-term inflation expectations are increasing. But the increases we have seen in the yield curve for nominal treasury securities, coupled with a relatively flat yield curve for TIPS, warrant an ever-watchful eye to make sure that long-term inflation expectations do not creep up.