One needs to remember that there are differences between inflation compensation and inflation expectations. In particular, the inflation compensation measures reflect not only investors’ expectations about inflation but also the amount they are willing to pay in order to protect themselves from inflation risk. In addition, the TIPS market is less liquid than the Treasury market, so there is a liquidity premium in inflation breakeven and compensation rates. We should expect the inflation risk premium and the liquidity premium to vary over time, so one needs to use a model to extract a measure of inflation expectations from inflation compensation. These models can produce very different estimates of the components depending on circumstances. For example, Figure 8 shows the inflation risk premia based on models maintained by the Cleveland Fed staff and the San Francisco Fed staff. You’ll note that even the signs can differ: in the most recent period, the San Francisco Fed model is estimating a negative risk premium while the Cleveland Fed model is estimating a positive risk premium. So the inflation expectations derived from these models can be quite different, as shown in Figure 9. In addition, at times, demand for Treasuries can increase significantly as investors seek safe haven flows for their money. This can make it even harder to infer inflation expectations from changes in inflation compensation. Finally, in the U.S., changes in the inflation compensation measures also seem to be correlated with changes in energy prices, a correlation that suggests they may not be reliable indicators of long-term inflation expectations.

Jon Faust and Jonathan Wright argue that market-based inflation compensation measures are too volatile to be plausible estimates of longer-term inflation expectations, and they show that the data reject the hypothesis that today’s five-year, five-year forward inflation compensation is a rational expectation of inflation in the long-run.

This means that one of the major benefits that were expected from the introduction of inflation-indexed bonds (Treasury Inflation-Protected Securities, generally called TIPS), namely that they would provide a quick and reliable measure of inflation expectations, has not been borne out, and that we still have to struggle to get reasonable estimates of expected inflation.

In the first instance, as already noted, core inflation can to some extent be influenced by oil prices. However, a larger effect comes from changes in the exchange value of the dollar, and the rise in the dollar over the past year is an important reason inflation has remained low.
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The dynamics with which all these factors affect inflation depend crucially on the behavior of inflation expectations. One striking feature of the economic environment is that longer-term inflation expectations in the United States appear to have remained generally stable since the late 1990s. The source of that stability is open to debate, but the fact that the Fed has kept inflation relatively low and stable for three decades must be an important part of the explanation. Expectations that are not stable, but instead follow actual inflation up or down, would allow inflation to drift persistently.
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We should however be cautious in our assessment that inflation expectations are remaining stable. One reason is that measures of inflation compensation in the market for Treasury securities have moved down somewhat since last summer. But these movements can be hard to interpret, as at times they may reflect factors other than inflation expectations, such as changes in demand for the unparalleled liquidity of nominal Treasury securities.

We refer to this in the statement as inflation compensation rather than inflation expectations.

The gap between the nominal yields on 10-year treasuries, for example, and tips have declined. That's inflation compensation. And five-year -- five-year forwards, as you said, have also declined.

That could reflect a change in inflation expectations, but it could also reflect changes -- changes in assessment of inflation risks, the risk premium that's necessary to compensate for inflation that might especially have fallen if the probabilities attached to very high inflation have come down.

And it can also reflect liquidity effects in markets, and for example, it's sometimes the case that when there is a flight to safety, that -- that flight tends to be concentrated in nominal treasuries and could also serve to compress that spread.

So I think the jury is out about exactly how to interpret that downward move in inflation compensation, and we indicated that we are monitoring inflation developments carefully.

In assessing inflation expectations, I currently put more weight on survey-based measures of inflation expectations as opposed to market-based measures. Survey-based measures have been generally stable, consistent with inflation expectations remaining well-anchored. However, market-based measures, such as those based on breakeven inflation derived from the difference between yields on nominal versus Treasury Inflation-Protected Securities (TIPS), have registered declines over the past few months, even on a 5-years forward basis. Research done by my staff suggests that much of this decline in market-based measures of inflation compensation reflects a fall in the inflation risk premiumthat is, what investors are willing to pay to protect themselves against inflation risk. Adjusting for the fall in the inflation risk premium, inflation expectations appear to have declined much less than implied by TIPS inflation breakeven measures.

Figures 2 and 3 showed that expectations for 2014 inflation have declined, and with inflation having consistently undershot the Federal Reserves 2 percent target, it is possible that longer-term inflation expectations are starting to decline as well. Figure 6 provides one way to capture longer-run inflation expectations. By subtracting the 10-year inflation-indexed Treasury yield (TIPS) from the 10-year Treasury yield, you get a measure of so-called break-even inflation. That is, this difference represents the prevailing inflation rate that should make you indifferent between holding a fixed-rate bond and holding a Treasury bond of the same maturity that floats with the inflation rate. The latest readings have been at the low end of recent experience. However, one must be cautious to infer too much from Treasury interest rates, particularly given the recent volatility and the flight to quality by many global investors that may have temporarily reduced Treasury yields.

MR. LACKER. Yes. I notice that in chart 18, in your TIPS-implied average inflationary plot to the ten-year horizon, you omit the Markets Group’s estimate. Is that because of skepticism on your part that leads you to judge it as inferior or an overabundance of humility? [Laughter]

MR. DUDLEY. The latter, of course. [Laughter]

MR. LACKER. It does, of course, show a slightly different trend, right?

MR. DUDLEY. It actually has increased a bit. But I have consistently shown just the Barclays and Board measures over the past few months, so this is not “pick and choose.”

The most prominent financial-asset-based measures are derived from Treasury Inflation Indexed Securities, commonly known as TIPS. These securities give the investor a fixed real return because their principal and interest payments are tied to the CPI. Regular Treasury securities are not tied to the CPI so breakeven inflation, the difference between nominal Treasury securities and TIPS, is used to infer expected inflation over length of the contract. However, it is difficult to extract a clean measure of inflation expectations from breakeven inflation. Two prominent problems are inflation uncertainty and liquidity risk.

A rise in inflation uncertainty is distinct from a rise in inflation expectations, although both impose costs on the economy. Rising inflation uncertainty - or, in other words, a widening in the range of plausible inflation outcomes - introduces a risk in making long-term contracts, particularly financial contracts. Investors look to be compensated for this risk, as they would for any other risk, making the terms of financial contracts more costly than they would be otherwise.

The second problem - liquidity risk - arises because the liquidity characteristics of the regular Treasury markets and the TIPS markets are not the same. The regular Treasury market is broader and deeper. So in periods of financial stress, such as those we have witnessed lately, large flights to quality might create a downward bias in breakeven inflation as a measure of inflation expectations.

Perhaps a more straightforward way to gauge inflation expectations is to simply ask people their views on inflation. In fact, the University of Michigan's monthly survey does just that. Unfortunately, we have problems with interpreting this data. For one thing, households' beliefs about future inflation are typically much higher than the actual inflation rate. Also, people are likely to report their inflation predictions in terms of whole numbers, and particular whole numbers at that. On average, women also tend to have higher inflation expectations than men, the poor higher than the rich, and the young and elderly higher than the middle-aged.[2]

These patterns in survey responses lead many to question the accuracy of using them to measure inflation expectations. When you get right down to it, they underscore the fact that we really know very little about how people form their inflation expectations. Economists at the Federal Reserve Bank of Cleveland, like many others, are pursuing research that seeks to better measure the inflationary expectations of households and businesses and to shed some much-needed light on the process by which inflation expectations are formed.

Until that time, I am left with the data I have in hand. Both the TIPS-based and survey-based measures of inflation expectations seem to have been fluctuating in a stable range during the past couple of years. In other words, inflation expectations appear to be anchored.

As for inflation compensation derived from spreads between yields on nominal and inflation-indexed Treasury securities (known as Treasury Inflation-Protected Securities, or TIPS), the implied rate of inflation compensation from five years ahead to ten years ahead (the so-called five-to-ten-year-forward rate) has risen somewhat since the beginning of the year.  Does this rise in forward inflation compensation indicate that long-run inflation expectations have risen by a similar amount?  My best guess is that much of the rise in inflation compensation reflects other factors.

To begin, recall that inflation compensation measured by using TIPS yields is not the same thing as inflation expectations.  Rather, movements in inflation compensation reflect not only changes in inflation expectations, but also changes in an inflation risk premium and in the relative liquidity of TIPS and similar maturity nominal Treasuries.  To see that these components are distinct, recall that during the period of heightened concerns about deflation in 2003 and 2004, forward inflation compensation rose substantially to an unusually high level amid concerns about an unwelcome fall in inflation; that earlier episode, in particular, underscores the fact that we must be careful in using the forward rates of inflation compensation as a gauge of long-run inflation expectations. 

Although inflation compensation over the next five years, as measured in Treasury markets, has been essentially unchanged recently, longer-run inflation compensation rose modestly, along with the rise in long-term rates that I discussed earlier. My guess is that this increase largely reflects an elevation in inflation risk premiums or the influence of some idiosyncratic factors affecting the demand for Treasury debt, rather than an increase in long-run inflation expectations. I base this conclusion on the fact that longer-run inflation compensation also ticked up in the United Kingdom, a country where inflation expectations have been remarkably well anchored over the past decade and where inflation has been trending downward. The fact that longer-run inflation compensation rose in both countries, despite their different monetary policy regimes, suggests that a common explanation is needed, rather than one specific to the U.S. This result suggests that inflation expectations in the U.S. continue to be well anchored as they have been for at least the past ten years or so, as the Fed has established its credibility with the public about both its commitment to and its competence in keeping inflation at low and stable rates.

Long-run inflation compensation derived from spreads between yields on nominal and inflation-indexed Treasury securities stood at 2.4 percent on May 30 (ten-year, adjusted for carry effect), in the middle of the range observed since the turn of the year.

Measures of inflation expectations obtained from financial asset prices clearly indicate that market participants expect that the Federal Reserve will maintain low and stable inflation. For example, although the difference between the yields on nominal inflation-indexed and Treasury securities is an imperfect measure that includes complicating factors such as inflation risk and liquidity premiums, the five-year break-even inflation rate five years ahead has averaged about 2-1/2 percent over the past five years and has fluctuated in a narrow range of about 1-1/2 to 3-1/2 percent. Survey measures confirm that inflation expectations over this period have been subdued and well anchored.

Unfortunately, as a measure of market participants' expected inflation, breakeven inflation has a number of problems (Sack, 2000; Shen and Corning, 2001). First, and probably the most important, breakeven inflation includes a return to investors for bearing inflation risk, implying that the breakeven rate likely overstates the market's expected rate of inflation. Estimates of the inflation risk premium for bonds maturing during the next five to ten years are surprisingly large, generally in a range between 35 and 100 basis points, depending on the time period studied (Ang and Bekaert, 2003; Goto and Torous, 2003; Buraschi and Jiltsov, 2004). If the inflation risk premium averages 50 basis points, for example, then breakeven inflation will overstate the market's true expectation of inflation by half a percentage point, a substantial amount. A further complication is that inflation risk premiums are not constant but instead appear to vary over time as economic circumstances change.

Second, although the issuance of inflation-protected securities has risen significantly, the outstanding quantities of these securities remain much smaller than those of conventional Treasury securities. Moreover, TIPS are attractive to buy-and-hold investors, in contrast to nominal Treasury securities, which are extensively used for trading and hedging (Sack and Elsasser, 2004). For both reasons, the market for TIPS remains significantly less liquid than those for most Treasury securities. All else equal, the likely presence of a liquidity premium in the TIPS return tends to make breakeven inflation an underestimate of expected inflation, thus offsetting to some degree the effect of the inflation risk premium. Like inflation risk premiums, liquidity premiums on TIPS appear to vary over time, further complicating the interpretation of breakeven inflation.

A third issue is that the real values of the coupon payments on an indexed security are fixed by construction, while the real coupons of a nominal bond usually decline over its life. Hence, an indexed security typically has a longer duration with respect to real interest rate changes than does the nominal security, a difference that affects the relative riskiness of real and nominal securities.4 More generally, because TIPS returns are imperfectly correlated with the yields on both nominal Treasuries and stocks, some investors demand TIPS for general diversification purposes--a demand that appears to have increased significantly as investors have become more familiar with this new type of asset. As the supply of TIPS has been fairly limited, the rise in demand by institutional investors and others may push down the equilibrium real return on TIPS and thus raise measures of breakeven inflation.5

A separate issue that bears on the relevance of breakeven inflation for policymaking is that TIPS returns depend on the overall consumer price index (CPI), whereas for many purposes policymakers are more interested in the behavior of core inflation, a measure of inflation that strips out volatile food and energy prices. In fact, TIPS returns appear sensitive to fluctuations in oil prices.