On the bond market's inflation forecasting abilities

How good is the bond market at anticipating inflation? Thanks to the advent of TIPS (Treasury Inflation-Protected Securities), we can now begin to answer that question in scientific fashion.

The chart above compares the actual rate of Consumer Price Inflation, using a rolling 10-yr annualized basis, to the market's expectation of what the CPI will average over the next 10 years (as embodied in the difference between the nominal yield on 10-yr Treasuries and the real yield on 10-yr TIPS). For example, in early 1999, the expected rate of inflation over the next 10 years (blue line) was a little less than 1% a year. Ten years later, in early 2009, the actual (annualized) rate of inflation over the previous ten years was 2.6%. Thus the bond market in 1999 underestimated future inflation by 1.6% a year, which adds up to a 17% cumulative miss.

Further, as the chart also shows, the bond market underestimated future inflation consistently from early 1997 through April 2001. In April 2001 the expected rate of 10-yr inflation was 2% per year, and we now know that the CPI has registered an annualized rate of increase of 2.7% over the 10-yr period ending April 2011.

On a less scientific basis, we can infer from this next chart that the bond market tended to underestimate inflation throughout most of the 1970s (because inflation exceeded 10-yr yields on average), and clearly overestimated inflation from the early 1980s until a few years ago (because yields greatly exceeded inflation).

In summary, inflation expectations embodied in TIPS pricing are not to be dismissed, but they need to be taken with a few grains of salt; the bond market is not infallible, and it has made some significant misses over the years in its estimates of future inflation. Regardless, I would note that since last August, when the Fed first floated the idea of QE2, 10-yr inflation expectations have risen from 1.5% to 2.4%, and the year over year change in the CPI has risen from 1.1% to 3.2%. Inflation and inflation expectations have moved significantly higher in the past year, even as they have declined modestly in the past month. Furthermore, the current real interest rate promised by 10-yr TIPS (the difference between current yields and current inflation) has narrowed quite a bit in recent years, thus offering investors who are looking for a real rate of return on 10-yr Treasuries a much smaller margin of error.

If I had to hazard a guess as to whether the bond market is more likely to over- or underestimate inflation in coming years, I would go for the latter. I base that on the Fed's clearly accommodative monetary stance, its avowed desire to push inflation higher, the historically low level of 10-yr Treasury yields, and the bond market's record of underestimating inflation during times of monetary accommodation (accompanied importantly by a very weak dollar and rising gold and commodity prices) as happened in the 1970s.

I refer readers to several of Mark Perry's posts in the past week for a reasoned but opposing viewpoint.