Party TIPS

If you’ve run out of ideas for party pick-up lines, try this:

“Hey precious… how much do you think prices will go up or down over the next 12 months?”

In case you’re dying to ask, I did try it. And, trust me, you’re guaranteed to get at least a few stares!

What you may also get is some spooky numbers. “One percent” said someone (hello? what world are you living in??). Another offered (an obscurely specific) 12.73 percent. True, some of the respondents were either pulling my leg or were already pretty drunk. So let’s discard the “outliers” and stick to the middle ground. The middle response (or median) was near 5 percent. That’s one percent higher than current inflation, which tells me that people expect prices can only go higher… and faster.

Anchors or spirals? Accurate or not, inflation expectations are an important input in the Fed’s decision-making process when it comes to setting interest rates. What the Fed cares about is that people’s expectations of inflation in the medium term remain “well anchored.” “Anchored” as in “relatively insensitive to news about the economy.” Why does this matter?

It matters because it has implications for actual inflation.

Let’s say for example that you’re flipping the TV channels and you hear that gas prices have shot up to nearly $4 a gallon. If your inflation expectations are “well anchored,” you’ll most likely yawn and continue flipping. For a moment, it might even cross your mind to postpone that summer road trip for next year: “Surely the surge is temporary,” you think. Or… “No big deal, the prices of other things will go down, as people spend more on gas and less on everything else.” Or.. “No matter what, the Fed is bound to do something about it!”

Now guess what will happen if your expectations are not “anchored”: Right, you (and your union) go to your respective bosses and demand a pay-rise. Bosses eventually bow to the pressure and your wages go up. But now companies’ wage costs have increased—so they decide to raise their prices even further—a vicious wage-price spiral!

This is exactly what the Fed wants to avoid. And in recent years it has been pretty successful in doing so. But is this about to change?

A penny for your thoughts: There is no shortage of indicators that try to gauge people’s expectations about inflation. Some are based on surveys with questions similar to my party pick-up line—though, admittedly, a tad more rigorous! What they tell us is a story that sounds spooky enough to catch the Fed’s ear.

Take for example the survey conducted by the University of Michigan. It shows that consumers now expect inflation in five years time to be around 3.3 percent. Hey, did I see you yawn? Fine, it’s not “scary-high” but it’s the highest it has been in more than a decade. Moreover, when it comes to short-run inflation expectations (over the next 12 months), these have arguably entered the “frightening” territory: At 5.2 percent, expected inflation is the highest since the early 1980s!

We also have the Survey of Professional Forecasters conducted by the Philadelphia Federal Reserve. “Professional” as in “(supposedly) better informed about prices, by virtue of their profession” (like Wall Street economists!). Once again, we have an increase in inflation expectations in recent months, though at levels that sound more benign—2.7 percent for inflation next year.

How much should we trust these people? I mean, they could well be drunk while the were answering the survey.. or incensed after having just filled up their gas tank.. or, simply, prone to error. Indeed, a historical comparison between the inflation expected in those surveys and actual inflation, points to frequent errors—positive or negative.

Put your money where your mouth is: There is also another indicator of expected inflation that the Fed looks at. That’s the inflation derived by comparing the yield of standard government bonds with the yield of government bonds that protect investors from inflation—the so-called TIPS (or Treasury Inflation-Protected Securities).

The idea behind TIPS is the following: Suppose I invest my money today in the usual (“nominal”) Treasuries, maturing, say, in five years. I then receive a fixed interest every six months and, after 5 years, I also get my principal back. This fixed interest rate will reflect investors’ expectations today for inflation over this five-year period: The higher the expected inflation, the more the interest investors demand, to keep their savings from eroding.

But what if inflation goes up unexpectedly? Yeap, I’m sc$*d… the (fixed) interest I receive will not compensate me enough for inflation and my savings will buy less “stuff” five years down the road. TIPS, on the other hand, offer protection against inflation by adjusting my returns every time inflation changes.

So, in principle, the difference between the yield of nominal treasuries and the yield on the TIPS (of the same maturity) should be equal to the market’s expectation of inflation. And since traders bet (a lot of) money into these securities, you would expect the calculation to give us the market’s best guess about future inflation.

Now, in practice, this simple subtraction does not give a clean-cut measure of inflation expectations (if you’re curious why, see here). So the Fed actually makes a couple of adjustments to make sure that apples are compared with apples.

So what do TIPS tell us? The “quick and dirty”, simple-subtraction approach shows that inflation expectations have remained remarkably stable over the past few months. Kind of weird, right? With oil prices double their levels a year ago, and other commodities rising at double digits, you wonder what on earth is going on in traders’ minds… Are they numb? Or do they foresee a calamitous collapse of the economy that will force prices down? But you may not have to go that far. If you see the inflation expectations derived after the adjustments I was talking about, there has been a clear upward move since late last year.

So… what’s happening? Are people losing trust in the Fed? Are we going to start seeing vicious wage-price spirals? Or should we brace ourselves for interest rate increases by the Fed later in the year?

Reading their signals: Truth is, when it comes to the link between inflation expectations and actual inflation, there are still too many question marks for the former to guide policy in a definitive way: For example, how do we, (economic) agents, form our inflation expectations? How exactly do people’s expectations respond to monetary policy? And, actually, are inflation expectations a good predictor of realized future inflation? The understanding of all these issues is evolving, yet far from perfect.

Importantly, the Fed continues to care quite a bit about employment and growth. And with house prices still looking for a bottom, the situation in the labor market fuzzy and credit markets on “ER” mode, controlling inflation expectations might look like a lesser priority–at least as long as the Fed continues to think (/wish) that commodity prices will “level off”… and that you’ll keep on yawning.

Originally published at Models & Agents and reproduced here with the author’s permission.

One Response to "Party TIPS"

  1. akmi   June 5, 2008 at 2:07 pm

    TIPS and Treasuries under- or over-predict inflation b/c their yields are sometimes driven by flight to safety or other things unrelated to inflation. Also, TIPS are indexed to CPI, which underestimates actual inflation because of OER, hedonic quality adjustments and geometric weighting/product substitution. The last time breakeven rates and consumer inflation expectations (as measured by Univ. of Michigan consumer survey) were in agreement was April 2006 – when both the markets and consumer over-predicted inflation.