What are bond prices saying about future inflation?
October 25, 2011
A typical government bond pays a nominal interest rate that includes a real yield and an expectation of future inflation such that:
1 + nominal yield = (1 + real yield) * (1 + expected inflation)
Thanks to the invention of inflation-linked bonds (TIPS in the U.S.), investors have a way of betting on future changes in the price level. This is why the expected inflation piece of the nominal bond yield is sometimes called the “break-even inflation” rate or BEI—the rate above which you make money buying TIPS and selling nominal bonds and below which you make money doing the reverse.
So what are the markets now saying?
The relative pricing of 30-year TIPS and 30-year Treasurys suggests that investors expect the CPI to rise—on average—about 2.2% a year for the next 30 years. How does this expectation conform with history? Put another way, if you had had the opportunity to bet on the level of the 30-year BEI at any point since the founding of the Federal Reserve in 1913, when would you have made and lost money?
Since the depths of the Great Depression, inflation rates over the next 30 years were faster than the current 30-year BEI.
Do the results look different when looking at 10-year periods? 10-year BEI is just about 2% as of this writing, which has been below the 10-year annualized average rate of inflation for the vast majority of the past 98 years:
So are TIPS a bargain relative to regular nominal bonds? Not necessarily. Simplistic studies of the past are unhelpful guides to the future. Inflation accelerates and decelerates over long periods of time depending on secular factors. Comparing today’s America with the U.S. of the late 1960s is clearly inappropriate, so bet wisely.