Wednesday, October 24, 2012

Behold the Power of the Rear View Mirror

St. Louis Fed President James Bullard, October 4, 2012

"Distant inflation expectations from the TIPS (Treasury inflation protected securities) market seem to suggest that investors do not completely trust the Fed to deliver on its 2 percent inflation target."

If the bond market doesn't trust the Fed then what does it trust?

Click to enlarge.

Ah, yes. It's the rear view mirror.

As seen in the black line on the chart, the average inflation rate from September 1992 to September 2012 was 2.50%.

The derived inflation rate using today's 2.55% yield on the 20-year nominal treasury and subtracting off today's 0.01% real yield on the 20-year TIPS gives us an average annual inflation expectation of 2.54% over the next 20 years. That is shown as the blue diamond on the chart.

What does this mean? The bond market expects the last 20 years to repeat. Maybe it will. Maybe it won't. In any event, this does not imply that the bond market is smarter than the stock market. Both markets apparently love staring into the rear view mirror.

I can't say that I can come up with a better guess for what inflation will do over the next 20 years. I'm really torn most days. My gut says 2.5% is probably a fairly good guess. Higher? Lower? Who really knows for sure? In general, this is why I prefer treasuries with inflation protection over those without it though. It's just one less thing I need to gamble on.

Source Data:
St. Louis Fed: CPI
U.S. Treasury: Daily Yield Curve
U.S. Treasury: Daily Real Yield Curve


CP said...

Can you do a chart of expected inflation vs realized inflation over that time period? Would be interesting to see when people were too optimistic vs too pessimistic.

Stagflationary Mark said...


I actually really wanted to do that. Unfortunately, TIPS weren't introduced until 1997. I therefore can't look back 20 years for even one data point.

I can provide a hint though.

On April 8, 1998, a 30-year TIPS was auctioned with a high yield of 3.74%. On that same date, the U.S. Treasury claims the 30-year nominal treasury yielded 5.90%.

The bond market therefore expected 2.16% inflation over the next 30 years (5.90% - 3.74%).

In April of 1998, the seasonally adjusted CPI was 162.200. In September of 2012, the seasonally adjusted CPI was 231.414.

That's an increase of 42.7% over 14.42 years. Inflation has actually been running at a 2.50% annual rate. The bond market now predicts more of the same.

It's not quite apples to apples, but I think it would be safe to say that the bond market underestimated inflation from 1998 to 2012.

I can't say I blame it all that much. There were quite a few deflationary forces. There still are.

That said, "the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.". Go figure.

Stagflationary Mark said...

I should add one more thing to the mix.

It has been my belief that comparing TIPS to nominal treasuries to determine future inflation expectations is more than a bit distorted. Here's why.

Investors who are absolutely sure that serious deflation will appear would flock to nominal treasuries.

Investors who are absolutely sure that serious inflation will appear would flock to hard assets. Not TIPS! As I have stated here many times, the taxation of TIPS would financially ruin me if we hyperinflate.

TIPS, to me, are therefore not the opposite of nominal treasuries. They are for the relatively humble investor who isn't sure what inflation will do and would like at least some insurance.

I therefore think that inflation will probably always be a bit higher than using TIPS math would suggest. It's just not balanced between the serious deflationists and the serious inflationists.

Just a thought.