Saturday, July 24, 2010

TIPS: A Gauge Of Inflation Expectations

Treasury Inflation Protection Securities or TIPS, are indexed bonds or bonds whose interest and principle payment are adjusted for changes in the price level.  The interest rate on these bonds provides a direct measure of a real interest rate. 

Using the Fisher equation:

i = ir + E(P)
i - nominal interest rate
ir - real interest rate
E(P) - expected inflation

We can re-arrange the terms to get:

Expected inflation rate for the next 10 years  =  ( (i) - Ten Year Treasury Constant Maturity Rate, monthly) - ((ir)- 10 Year TIPS, Monthly)

Using FRED:

So the expected inflation rate for the next 10 years is around 3.2%.

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