Magazine article Economic Trends

Inflation Expectations and Monetary Policy

Magazine article Economic Trends

Inflation Expectations and Monetary Policy

Article excerpt

06.09.09

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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 two 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.

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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. …

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