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TIPS and Forecasted Inflation

Bloomberg ran an article stating that the widening spread between TIPS and nominal Treasury bonds indicates that investors are now more concerned about inflation. The implication is that Federal Reserve Chairman Ben Bernanke has won the deflation battle and now the Fed must shift its focus to fighting inflation. "[The spread] shows traders expect inflation, not deflation in coming months, said Jay Moskowitz, head of TIPS trading at CRT Capital Group LLC in Stamford, Conn. Let me offer an alternative interpretation.

While the conventional wisdom seems to be that the spread between the 10-year nominal Treasury and the 10-Year TIPS is explained by expected inflation, there are other factors. Consider that the yield on nominal Treasuries is actually made up of three components:

  • The real yield
  • The expected rate of inflation
  • A risk premium for unexpected inflation
With TIPS, the yield is made up of two parts:
  • The real yield
  • A risk premium for liquidity
While TIPS have no credit risk, they're less liquid than nominal Treasuries. During financial crises like the kind we have just experienced, that liquidity risk shows up, and the risk premium (which in normal times might be very small) can rise dramatically, as the following example illustrates.

On October 31, 2008, the yield on 10-year TIPS was 3.35 percent, and the yield on the 10-year nominal bond was 3.97 percent. If you took the spread as an indication of inflation expectations, you would believe the market was forecasting inflation of just 0.62 percent. Yet, the Philadelphia Fed Survey of Professional Forecasters (a good indicator of the market's forecast) had a 10-year inflation forecast of 2.5 percent. Using that metric, the yield on the 10-year TIPS should have been around 1.5 percent (3.97 - 2.50), less any risk premium for unexpected inflation. While we can't know exactly what the risk premium for unexpected inflation was, we know it wasn't zero. Thus, we can conclude that there was a large liquidity premium in TIPS yields.

The fact that the spread between TIPS and nominal bonds has narrowed isn't a reflection of the widening of inflation expectations. Instead, it's a function of the dramatic fall in the liquidity premium in TIPS. In fact, the Philly Fed's survey of future inflation has actually dropped from 2.5 percent to 2.3 percent.

The fact that the liquidity premium in TIPS appears to be gone is good news. The financial markets have to heal before the economy can.

Now, let's analyze current yields. The gap between the 10-year nominal bond and the 10-year TIPS (currently at around 3.7 percent and 1.4 percent, respectively) is virtually identical to the Philly Fed's estimated inflation rate. That means that TIPS investors are not paying any risk premium for unexpected inflation, or, any risk premium is offset by a now small liquidity premium) And that makes TIPS an exceptionally good buy relative to nominal bonds. After all, when was the last time you bought insurance without paying a premium?

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