Is inflation on target? (corrected)

The new BLS unemployment numbers (9.1% unemployment rate, 16.1% comprehensive unemployment rate, 117,000 new jobs created) are the talk of the morning. I don’t have much to add to it, but I’ll echo the oft-made point that job growth needs to be twice as fast for the next several years for unemployment to fall to normal levels. I’ll also note that the numbers are a bit better than those of a year ago, but a bit worse than those of March, when unemployment was 8.8%. So although the numbers are better than expected, they’re still underwhelming and we still might be in a double-dip recession.

Instead I want to focus on the other big economic variable. Inflation has been so low over the past few years — in the range of 1-2% — that Ben Bernanke and others have seemed more worried about deflation than inflation. At the same time, some Fed critics have charged that the Fed’s actions to backstop dodgy financial asset markets and flood the banks with new reserves will lead to a massive inflation after the slump is over or a stagflation (stagnant economy with high inflation) even sooner. Some numbers to remember: Inflation has averaged 3% a year over the past century, and close to that over the past few decades. The Fed’s unofficial target for inflation is 2%. What do the markets expect for the years to come?

A good way to answer that question is to compare the well-reported interest rates on regular Treasury bonds with the interest rates on “TIPS” — Treasury Inflation-Protected Securities. The payments on a TIPS bond are adjusted for whatever inflation occurs over the bond’s lifespan.  The inflation adjustment is trickier than I’d originally thought — instead of simply adding the inflation rate to the interest rate that arose from the bond’s auction, the interest rate stays the same but the bond’s principal rises, and the interest payments are based on the original interest rate times the new principal. (Ex.: Imagine a 1-year, $1000-face-value TIPS bond that sells at par, i.e., for $1000 and therefore has an interest rate of 0%. If inflation is 3% over the next year, then the principal rises 3% to $1030. The interest is still $0, but the overall yield on the bond is 3% ($30/$1000). That’s a simplified example. It’s more complicated if the interest rate isn’t 0%.) Because the arithmetic can get complicated, it’s easier to look up the “breakeven” rate, which is the inflation rate implied by the different on TIPS and ordinary T-bonds.

(Add to that a conceptual complication: Because the TIPS bond is less risky, since it’s indexed for inflation, it should be in somewhat greater demand than the regular T-bond. So, other things equal, it should command a higher price and pay a lower interest rate. With that in mind, the difference between the interest rates on regular T-bonds and TIPS bonds is roughly the expected inflation rate plus an inflation-risk premium, which reflects people’s uncertainty about future inflation.)

Comparing the interest rates for 5-year bonds last week (when this was originally posted), the  T-bonds paid 1.12% and the TIPS paid -0.67%. The implied inflation rate (1.80%, if my spreadsheet math is correct) is actually very close to the difference in the interest rates on the two bonds (1.79%). Apparently the market is expecting the Fed to be just shy of its 2% target over the next 5 years.

Looking at the 10-year bonds, the T-bonds paid 2.47% and the TIPS paid 0.24%. The 2.03-percentage-point difference is again a close approximation of the breakeven rate; my spreadsheet math yields an expected inflation rate of 2.22%, or slightly over the Fed’s target. Together the two breakeven rates imply that the market is expecting inflation to average about 2.6% in years 6 through 10. These numbers provide no guide to where they think that inflation is going to come from (recovery? shortages of gas or food? QE5?), but the weakness in the stock market suggests they’re not expecting a recovery anytime soon. It may just be that their flight to safety has gone into overdrive, and TIPS are in exceptionally heavy demand because they are even less risky than regular T-bonds. So possibly they’re expecting inflation rates of about 1% through 2016 and 2% in 2016-2021, with the remainder being a risk premium.

In sum, the Fed does seem to be hitting its inflation target, more or less, but that’s about all. Bondholders appear willing to lock in near-zero or negative real returns over the next five or ten years, just so they can hold a safe asset. Which suggests they’re scared shitless.

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