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Inflation Swaps

One way to find out what markets expect for future inflation is to look at the inflation swaps market. In an inflation swap, one side makes a variable payment that is based on the realized inflation rate, and the other makes a fixed payment. To make the swap fairly priced, the fixed payment must approximate the expected value of inflation. Since actual inflation is uncertain, however, there is a risk premium involved as well.

One nice thing about inflation swaps is that they trade in an active market, making prices available at a high frequency. Thus it’s possible to see how expectations of inflation change day by day and week by week. A look at the swaps market shows that five-year inflation expectations have declined steadily since the spring of this year, leading some experts to worry about the possibility of deflation. Since September, however, the trend has reversed, and expectations have moved back up into the 2 percent range.

Five-Year Expected Inflation Rate

The timing of this increase in inflation expectations is significant. Inflation expectations reached a nadir in late August. Between the September and November Federal Open Market Committee (FOMC) meetings, information on the potential purchases of additional assets was gradual revealed. In particular, the release of the September meeting minutes on October 12 revealed that several members of the FOMC “would consider it appropriate to take action soon,” unless “the pace of economic recovery strengthened or underlying inflation moved back toward a level consistent with the Committee’s mandate. . .” This and other communications seem to have altered inflation expectations, as the likelihood of further purchases rose. Inflation expectations have been fairly stable since the November 2-3 FOMC meeting.

Year Expected Inflation Rate (2010)

By combining different maturities of inflation swaps it is also possible to get measures of forward inflation rates, that is, what inflation is expected to be in the future. Looking at expectations of the three-year inflation rate two years in the future (for example, inflation between 2012 and 2015, as in the chart below) shows a similar pattern of decline and recovery, though rates are higher, approaching 2½ percent.

Three-Year, Two-Year-Forward Inflation Rate

The level of three-year inflation expectations two years in the future appears to be above the FOMC view of inflation rates consistent with price stability; however, this measure does not account for risk premia that are relevant in these contracts. The Federal Reserve Bank of Cleveland’s model of inflation expectations is able to account for these risk premia and finds that inflation expectations remain lower, in the 1.5 percent range.

Three-Year, Two-Year-Forward Inflation Rate

These measures may give estimates that are different from those gotten in a popular way, which is to compare the interest rate on Treasury bonds that are protected against inflation (TIPS) with ordinary, nominal Treasury bonds, which are not. The difference between those rates, often called the breakeven rate, is the estimate of expected inflation. Using inflation swaps to gauge expected inflation has an advantage over the TIPS-based way because the difference between TIPS and Treasury rates can change with liquidity differences between the two instruments. However, the breakeven rate, whether derived from TIPS or from inflation swaps, also includes an inflation risk premium, and so is not a pure measure of inflation expectations. Getting a pure measure of expected inflation is possible, but it is more difficult to update day by day and to see high-frequency patterns. (For more detail, see our inflation expectations page. And as always, market conditions, taxes, and other complications mean these series must be taken as estimates of the underlying expectations, and so used with care.)

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