A Look At TIPS Inflation Expectations

Here is the expected inflation. As stated before, (5 year nominal interest rate treasuries - 5 year TIPS) = expected inflation for next five years.

A look at the 5 year TIPS itself:

Is there possible deflation on the horizon?

Revised to be relevant and useful: TIPS and Inflation Expectations

In a previous post  I calculated expected inflation using some bond that was maturing in 2012 but we want to get a more accurate (and relevant) picture of expected inflation.  To do this we can go to the Federal Reserve and observe statistical release H.15 which are selected interest rates.  For example, 10 years from July 22nd expected inflation is:

E(p)= i - ir
Where E(p) is expected inflation,
i - nominal interest rate ( interest rate paid on nominal treasuries)
ir - real interest rate (remember the inflation index bonds are supposed to reflect these)

Looking at the statistical release if we want the 10 year inflation expectations we must look at the 10 yr bonds.  We will find that for July 22, 2010:

i (Nominal Treasury) = 2.9%
ir (Inflation indexed Treasury) = 1.78%

2.96% -1.78% = 1.18% 
E(p) = 1.18%
Therefore expected inflation for the next 10 years as of July 22nd is 1.18%

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)
where:
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%.