Wednesday, September 3, 2008

The bond market is not a good inflation predictor

Many pundits have argued that inflation is not a problem because the bond market is not at all worried about inflation. They point to the spread between the yield on Treasury bonds and TIPS (commonly referred to as "breakeven inflation"), which is arguably the best measure of the bond market's inflation expectations. Right now the bond market is saying future inflation will average about 2% a year. As this chart shows, however, the bond market has been underestimating inflation for most of the time since TIPS came into existence in 1997. When TIPS were first issued, the 10-year expected inflation rate was 3.0% annualized. Ten years later, the CPI rose at an annualized rate of 2.5% Not bad, you might say. But look what happened in the summer of 1998: 10-year expected inflation was less than 1% per year, and instead it's been 3.0%. Currently, we see that expected inflation is falling, probably because oil prices are falling (though they are still extremely high and likely to be passed through to the consumer for many products and services). At the same time, though, actual inflation is rising sharply. Will the market's forecast of falling inflation prove correct? We can't know for sure, but if inflation ends up being higher than 2.0% in coming years, then buying 10-year TIPS today will be a better investment than 10-year Treasury bonds.

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