The Fed’s inflation target is 2% PCE inflation. Since 1967, CPI inflation has averaged 0.5 percentage points higher than PCE inflation. Putting these two points together, we see that expected inflation over the next five years is very close to target (h/t Mark Zandi).
figure 1: The five-year inflation breakeven is calculated as the five-year Treasury yield minus the five-year TIPS yield (blue, left scale), adjusted for the inflation risk premium and the liquidity premium per DKW (red, left scale), All are in %. The light blue dashed line represents 2.5% CPI inflation, in line with 2% PCE inflation. Recession dates as defined by NBER are shaded in gray. Source: FRB via FRED, Treasury, NBER, KWW Following D’amico, Kim and Wei (DKW) access 8/4, and author’s calculations.
This feature uses the traditional 5-year Treasury-TIPS spread as the market’s measure of expected inflation. Another measure of estimating inflation compensation (red line), taking into account inflation risk and a liquidity premium, suggests we are below target.
