One straightforward method to monitor the market’s expectation for future inflation is to measure the difference in yield between two U.S. Treasury securities,one that adjusts for inflation and one that does not. These two securities need to be issued at the same time and equal in time to maturity for a direct comparison. For example, comparing a 10 year U.S. Treasury bond and a 10 year U.S. Treasury Inflation Protected bond (TIP) will provide the market’s expectations for annualized inflation over the next ten years. These two securities are nearly identical because they are both backed by the credit of the United States government and both mature ten years after being issued. They differ in one key way. The TIP bond adjusts annually for inflation while the other, nominal security, does not. The reason that the nominal Treasury bond yield is typically higher than the TIP yield is that an investor who purchases the nominal security is not protected against inflation and desires to be compensated by way of extra yield. Inflation will chip away at the value of the coupon received each year causing the real value of the coupon payment to be less each year. (The purchasing power of $1 today is greater than $1 next year if inflation has occurred.)
In the first chart below both the 10 year nominal Treasury yields and the 10 year TIP yields are shown since early 2003. The difference between the two, known as a spread, is illustrated in the second chart. From early 2003 until mid 2008 inflation was generally expected, over a period of 10 years to average between 2.0% and 2.5% per year. Actual inflation, as measured by the consumer price index, over this time period averaged about 3.0% per year. Beginning in the fall of 2008 as economic conditions began to deteriorate the expectations for inflation in the United States fell dramatically. By the end of 2008 inflation was expected, over the next ten years, to average close to zero. From the beginning of 2009 until the middle of 2010 expectations for inflation rose back to a more normal level of an annual 2.5%. However, over the past three months, inflation expectations have once again decreased.
10 Year U.S. Treasury Yields
10 Year TIPS Spread
(10 Year U.S. Treasury minus 10 Year U.S. Treasury Inflation Protected Security)