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Market-based inflation expectations for the next five years


Relying heavily on a simple inflation break-even calculation that shows inflation over the next five years is lower than it was when Russia expanded its invasion of Ukraine.

figure 1: The five-year inflation breakeven is calculated as the five-year Treasury yield minus the five-year TIPS yield (blue), and the five-year breakeven is adjusted by the inflation risk premium and the liquidity premium per DKW (red), both in %. Source: FRB via FRED, Treasury, NBER, KWW Following D’amico, Kim and Wei (DKW) access 9/7, and author’s calculations.

Two series are plotted. Why is this distinction important? Consider the case of a 10-year inflation breakeven calculation. If the 10-year TIPS depends on the expected one-year real interest rate and liquidity premium (lp), then:

The liquidity premium is defined as the premium due to the low liquidity of the TIPS market; from Andreessen, Christensen and Riedel (2020): “Despite the size of the TIPS market, numerous studies have shown that TIPS are less liquid than treasuries that are not inflation-indexed

So a simple break-even calculation is:

If the term premium for nominal bonds and the liquidity premium for TIPS are zero (or each move in tandem), then the gap between 10-year Treasuries and 10-year TIPS can be attributed to expected inflation over the next decade. However, this is unlikely to be correct, so the break-even point usually calculated may be in error, which may vary systematically throughout the business cycle. The same applies to the five-year spread.

Note that an adjusted series – as opposed to an unadjusted series – means no rise and then a fall. Rather, it gradually increased from about 2% to 2.4%. So the adjusted series implies higher inflation than before the invasion, but never as high as the March unadjusted series would suggest.

Since the CPI is about 0.5 percentage points higher than the PCE deflator, this suggests that the PCE’s five-year inflation rate is about 2% of the Fed’s target.



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