# Posts Tagged inflation rate

## Introduction

Economists take it for granted that everyone knows the definition of the real interest rate: r = i – p where i is the nominal interest rate and p is the inflation rate.  The real interest rate measures the net transfer of purchasing power from borrowers to lenders.  Lenders will be repaid i dollars per hundred dollars loaned per year, but the purchasing power of those dollars will decrease by the inflation rate, p.  The purpose of this post is to show you how to use market data to measure expected inflation

In principle this is easy.  If the market interest rate is 3% and inflation is 1%, the real interest rate is 2%.  But if we want to look at future interest rates we need some measure of expected future inflation.

Individuals are, naturally, free to develop their own forecasts of the future inflation rate.  This article shows how to use publicly available data to calculate the market’s average expectation of future inflation rates.

## TIPS

TIPS stands for Treasury Inflation-Protected Securities.  These securities are issued by the U.S. Department of Treasury.  Follow that link to learn the details of how it works (links to Treasury site).  Since TIPS are adjusted to compensate for inflation, their yield to maturity is the real interest rate.  It’s helpful to know that TIPS are issued in maturities of 5, 10, and 30 years.  The minimum purchase is a measly \$100.

## Calculating Expected Inflation

The expected future rate of inflation over 5, 10, and 30 year horizons is the difference between ordinary Treasury securities with those maturities and the yield on TIPS.  This is an approximation because coupon payments on ordinary Treasuries are constant, but the coupon (and maturation value) on TIPS securities adjust to the inflation rate.  But let’s not allow details to get in the way of a good story.

As of October 14, 2011, here’s what the markets are forecasting for expected inflation:

 Maturity (years) Nominal yield TIPS yield Expected Inflation 5 1.12% -0.54% 1.66% 10 2.26% 0.28% 1.98% 30 3.22% 1.12% 2.10%
For those who want data sources, etc., e-mail me for an Excel 2011 workbook.

### Prof. Blanchard Gets It Wrong — Again

Prof. Olivier Blanchard (of M.I.T., currently at the I.M.F.) has a long history of getting it wrong when it comes to macroeconomic policy.  His most recent pronouncement, unfortunately, continues this trend.  Even worse, his policy prescriptions are now being made from the lofty pulpit of the International Monetary Fund where he is chief economist.[1]

Let’s see what Dr. Blanchard has to say.  This from an interview in the Wall Street Journal:

So should we change the inflation target?

Blanchard: If I were to choose inflation target today, I’d strongly argue for 4%. But we have started with 2%, so going from 2% to 4% would raise issues of credibility. We should have a discussion about it.”[2]

Blanchard’s argument is that by raising the inflation target, nominal interest rates would be higher.  This, he proposes, would give central banks more room to reduce interest rates to stimulate the economy.

Unfortunately, Prof. Blanchard has made an error that should make him blush.  It is the real interest rate, not the nominal interest rate, that affects most economic activity.  The only way Prof. Blanchard’s model can work is by appeal to the long-discredited “money illusion” hypothesis.

For those who are a bit rusty, recall that the nominal interest rate is made up of two parts.  The first is the real interest rate.  This is the net transfer of purchasing power from borrowers to lenders.  The second part is the expected future inflation rate.  Changes in the expected future inflation rate, however, have no – zero – impact on the real rate.

This is especially true if (or when) the central bank announces the new inflation target in advance.  Thus by publishing his paper Prof. Blanchard has destroyed any possible impact from the very policy he is advocating.

This stuff ain’t all that hard.  Frankly, it’s embarrassing when highly-placed economists get it this wrong.

[1] Technically his title is Economic Counsellor and Director of the Research Department of the International Monetary Fund.  For more biographical information see http://www.imf.org/external/np/bio/eng/ob.htm. Accessed March 9, 2010.

[2] “Q&A: IMF’s Blanchard Thinks the Unthinkable” by Bob Davis.  Wall Street Journal Real-Time Economics blog, February 11, 2010.  Available at http://blogs.wsj.com/economics/2010/02/11/qa-imfs-blanchard-thinks-the-unthinkable/?KEYWORDS=Blanchard+IMF. Accessed March 9, 2010. Those who want more details should see Blanchard, Olivier J. ; Dell’Ariccia, Giovanni ; Mauro, Paolo, “Rethinking Macroeconomic Policy,” Staff Position Note No. 2010/03, International Monetary Fund, February 12, 2010.  Full text available at http://www.imf.org/external/pubs/ft/spn/2010/spn1003.pdf. Accessed March 9, 2010.