Use Market Data to Measure Expected Inflation

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: