Market-Based Inflation Expectations Reflect No Fear of Inflation in the Medium and Long-Term
In normal times, the Federal Reserve can affect nominal and real interest rates by setting a target for the federal funds rate, an overnight rate for funds exchanged between banks. Because that rate has been near zero for some time, the Federal Reserve has turned to other policy tools. One such tool is the language used in policy statements and press releases. Another is the expansion of the types of securities it holds.
Some people have criticized these new actions, fearing that the Fed is going to create out-of-control inflation. One way to check how widespread these fears are is to look at market-based measures of inflation expectations. Market-based measures are useful in this regard because they reflect what investors expect future inflation will be—in fact, they have bet their own money on their expectations. What we can see from these measures is that the markets put negligible weight on a high inflationary environment in the medium- and long-term future. Actually, these expectations dropped significantly even after the Fed announced its most recent policy change.
We use two types of market-based measures of inflation expectations. One is the spread between nominal Treasuries and inflation-indexed Treasuries, and the other is inflation swap rates. The spread between nominal and inflation-indexed Treasuries is called the “breakeven inflation rate” or “inflation compensation.”
First we look at medium-term inflation expectations from inflation swaps (2 to 4-year maturity). These expectations followed a declining trend from the end of April to late August. Since then, their movement has been volatile, though at a low level. On August 25, 2011, the 2-year inflation swap was at 1.22 percent, about 1.5 percent lower than its peak in 2011. The same was also true for the 3- and 4-year inflation swaps, which were about 1.2 percent and 0.9 percent lower than their peaks in 2011, respectively. We saw a very modest increase in all the medium-term swaps on the day the August FOMC statement was released, August 9. After the last week of August, swap rates started to increase. For example, the 2-year swap rate increased to 1.61 percent on September 21, about a 47 basis point increase from its lowest level in 2011 (on August 18). However, after the September 21 FOMC announcement, we again see a declining trend. The same 2-year inflation swap rate had declined to 1.17 percent by the end of September.
Next, let’s turn to the 5- and 10-year inflation swaps and breakeven inflation rates. We see that inflation swaps are higher than the breakeven inflation rates for the same maturities. The difference is most likely related to a liquidity premium that is incorporated into the yields of the inflation-indexed Treasury securities. Since the breakeven rate is the difference between the nominal and inflation-indexed (real) yields, a positive liquidity premium in the latter may underestimate inflation expectations. In addition, there are other sources of bias in the breakeven rate such tax differences. On average, the difference between the swap rates and the breakeven inflation rates for 2011 is 31 basis points for the 5-year maturity and 35 basis points for the 10-year maturity.
When we look at the evolution of these rates, we see that they have been declining since late July. There also have been no noticeable changes around the FOMC meetings. For example, the 5-year break-even rate declined from 2.11 percent on July 28, 2011, to 1.5 percent at the end of September. In the same period, the 10-year inflation swap rate fell 61 basis points, from 2.81 to 2.20 percent. Although these crude measures for long-term inflation expectations have fallen sizably recently, they are still about 20-30 basis points above their lowest level in the last two years. That level was reached in late August 2010, a period just before the Federal Reserve Chairman Ben Bernanke hinted at a further monetary expansion, dubbed QE2.
When we look at even longer measures of inflation expectations, we see that the decline of these expectations in the last two months is rather prevalent over the whole term structure. For instance, the 20-year inflation swap declined more than 60 basis points between the end of July and September, whereas the 30-year breakeven rate for the same period declined about 85 basis points to 1.88 percent.
Finally, let’s look at the forward measures computed from the breakeven rates and the swap rates. These measures look at the period between a point in future and a further point in the future. Their appeal is that they give a view of future inflation abstracting from current short-term shocks. The evolution of these rates also reflects the same general decline as in the other market-based inflation expectations over the last two months.
Of course, we cannot associate all the swings in the market-based measures of inflation expectations with the policies or the policy announcements of the Fed. Like any other macroeconomic variable, the expectations are affected by other variables and beliefs about future economic conditions. Even when we look at the effects of just the statements, we have to recognize that other information could be figuring in, like the Federal Open Market Committee’s assessment of recent economic conditions. It is very hard to disentangle the effects of such assessments from the announcements of the policy changes. However, looking at the data, it seems that market participants who actually bet their money on the future inflation outlook did not see an inflationary threat in the Fed’s recent policy actions.