Market-based Inflation Expectations
Some prices and price indexes have shot up recently, but measures of core inflation have remained low. The consumer price index (CPI) rose 5 percent in annualized terms from January to February and 2.9 percent over the previous year. Energy prices rose by 45.7 percent in annualized terms during the month, and gas prices were responsible for almost 80 percent of the monthly increase in the CPI. On the other hand, underlying inflation series do not show an increasing inflationary trend. Indeed, three-month changes in these series show a decline after the summer and fall of 2011.
For more insight into where the rate of inflation is likely to head in the future, we look at a couple of measures that tell us how markets are currently pricing future inflation. These measures are inflation swap rates and breakeven inflation rates. Breakeven inflation is the difference between the interest rate on Treasury bonds that are protected against inflation (TIPS) and nominal Treasury bonds, which are not. Inflation swaps are derivatives used to hedge against inflation (more here).
First, let’s look at short- and medium-term expectations calculated from inflation swaps. The rates on one- to four-year inflation swaps have increased considerably since last October. The increase in the one-year swap rate is higher than the longer-term swap rates. The one-year swap rate increased by 1.13 percent between October and March, ending at 2.30 percent on March 27. In the same period, the two-year swap rate increased by 92 basis points and the four-year swap rate increased by 69 basis points.
Although the rapid increase between October and mid-March seems to reflect concern for higher inflation in the short-to-medium term, we have to note that these rates currently signal an inflation level slightly above the Federal Reserve’s long-run target of 2 percent. In addition, neither these levels nor the rapid movements are uncommon for the swap rate data.
Next, we check longer-term market-based expectation measures. In particular, we look at the five- and ten-year inflation swap rates and the breakeven inflation rates. All these rates experienced a path similar to those of the short- and medium-term measures. After a small decline in the second half of March, the five-year breakeven rate is at 2.01 percent, and the ten-year breakeven rate is at 2.33 percent on March 27. The five- and ten-year inflation swap rates are 2.37 percent and 2.66 percent, respectively. Again, although the breakeven and swap rates are significantly higher for five- and ten-year maturities compared to the last fall, they do not signal a significant inflationary threat.
Finally, we check the forward measures of long-term inflation expectations, that is, expectations of the inflation rate that will prevail for a specified period beginning x-number of years in the future. Specifically, we check the five-year, five-year forward and the ten-year, ten-year forward measures of inflation calculated from swap rates, as well as the breakeven inflation rates. These longer-term rates have increased, too, since October, though to a lesser extent than the shorter-term measures we considered. In addition, the forward measures for the longer term are lower than the shorter term. For example, the five-year, five-year forward inflation swap rate is currently at 2.95 percent, while the ten-year, ten-year forward breakeven inflation rate is 2.85 percent. The breakeven inflation rates for the same maturities are 2.65 percent and 2.47 percent, respectively.
Overall, we have seen a sizable increase in market-based measures of inflation expectations since last October, especially for shorter maturities, followed by a reversal in the second half of March. However, these inflation measures still do not reflect a rapid inflationary period in either the medium or long term. In fact, all market-based inflation-expectation measures up to five-year maturities are currently below 2.5 percent, and the measures for longer-term are below 3 percent.