Inflation Expectations: A Primer

By James Kwak

Only a few years ago, the accepted remedy for a recession was for the Federal Reserve to lower interest rates - namely, the Federal funds rate. Now, however, the economy has been stuck in recession for over fifteen months and the Federal funds rate has spent the last several months at zero. (The Fed funds rate cannot ordinarily be negative, because one bank won’t lend $100 to another bank and accept less than $100 in return; it always has the option of just holding onto its $100.) As a result, the Fed has resorted to other policy tools, most notably large-scale purchases of agency and Treasury securities, funded by creating money. (Here’s James Hamilton’s analysis.)

As the Fed’s monetary policy plays a more prominent role in the response to the economic crisis, there will be more talk of inflation or, more accurately, inflation expectations. While inflation is what affects the purchasing power of the money in your wallet, inflation expectations are what affect people’s behavior in ways that have a long-term economic impact. Take the case of wage negotiations, for example: a union that believes inflation will average 5% over the life of a contract will demand higher wage increases than a union that believes inflation will average only 1%. Once those higher wages are built into the contract, the employer is forced to raise prices in order to cover those wage increases, and inflation begins to ripple through the economy.

One of the major objectives of modern monetary policy is to control inflation expectations, because controlling inflation expectations is the first step to controlling inflation. If there is a short-term burst of inflation - as we had a year ago, if you look at headline inflation numbers that include the prices of food and energy - the macroeconomic consequences can be limited if people believe that the Fed can and will bring inflation under control.

Unfortunately, it is impossible to know exactly what people’s inflation expectations are; in fact, it may not even be a sensible question, since different people have different understandings of what inflation is. However, there are three main approaches to estimating inflation expectations.

1. Inflation-indexed government bonds. (If you need a refresher on how a bond works, read the first part of this article.) A traditional bond is a stream of payments that is fixed in nominal terms: for example, $100 in 10 years, and 6% interest, paid semi-annually ($3 every 6 months). Such a bond is not inflation-indexed; if inflation goes up, the purchasing power of that $100 goes down, and it’s too bad for the bondholder.

An inflation-indexed bond, by contrast, pays an amount that is indexed to some measure of inflation. In the U.S., where these bonds are called Treasury Inflation Protected Securities (TIPS), we use the Consumer Price Index. A TIPS bond may have a $100 face value and pay a 2% interest rate. However, every 6 months, that $100 face value is adjusted to reflect the change in the CPI, and the interest payment is calculated as a percentage of the adjusted value of the bond. Then, after 10 years, the bondholder gets back not $100, but $100 times the ratio between the CPI at the end of the period and the CPI at the beginning of the period. This way the bondholder is guaranteed a 2% real return (assuming he paid $100 for the bond), no matter what the rate of inflation is in the interim.

The implied inflation expectation, then, is the difference between the yield on an ordinary bond and the yield on an inflation-indexed bond with the same maturity. If the 5-year Treasury has a yield of 4% and the 5-year TIPS has a yield of 2%, then inflation expectations for the next five years are (about) 2% per year. The reasoning is that in order to buy the regular bond as opposed to the inflation-indexed bond, an investor has to be paid a higher yield to compensate him for the level of inflation that he expects.

Actually, in addition to expected inflation, the Treasury investor also has to be paid an inflation risk premium because, all things being equal, it is better not to have inflation risk than to have it. So the implied inflation expectation is actually slightly less than the spread between the regular and the inflation-indexed bonds. If you didn’t follow that, don’t worry, just remember that, roughly speaking, Treasury yield = TIPS yield + expected inflation.

2. Inflation swaps. These are a type of derivative contract, where the payments under the contract depend on the value of an inflation index, such as the CPI. The swap has a nominal value of, say, $100, but $100 never changes hands. Instead, at the end of some period of time, party A pays party B a fixed rate of interest on $100 - say 2.5% per year. At the end of the period, B pays A the cumulative percentage change in the inflation index over the period. Assuming A has $100 in his pocket, he has now hedged the inflation risk on that $100, because no matter what happens, at the end of the period he will get an amount that compensates him for the impact of inflation on his $100. The price of this hedge is $2.50 per year. (Because these are over-the-counter contracts, there are many variations on this, including swaps with periodic coupon payments.)

For the same reasons described above, the implied inflation expectation is roughly 2.5% per year: party B thinks inflation will be less than 2.5% per year, and therefore is willing to take 2.5% and pay the amount of inflation; party A thinks inflation will be more than 2.5% per year, and therefore is willing to pay 2.5% per year to get the amount of inflation back. So the market clears at 2.5%. (Actually, for the exact same reasons as with bonds - party B has to be paid an inflation risk premium for absorbing the risk in this trade - the inflation expectation is slightly less than 2.5% per year. There are also some complications having to do with the lag in the publication of inflation indices, but let’s ignore that for now.)

One curiosity is that the inflation-indexed bond method and the inflation swap method can produce different estimates. Theoretically this should not happen, because if two products that will have the same price in the long term (since they are based on the same index) have different prices today, there should be an arbitrage opportunity. Why this happens in practice is discussed on pp. 5-6 of this Bank of England paper. (Thanks to Bond Girl for pointing out the paper.)

3. Surveys. You can also just ask people what they think inflation will be. Economists ordinarily prefer markets, under the principle that when people are paying money they are signaling what they really believe. But if you think there are sufficient problems with the markets you may want to go with surveys. Tim Duy has a post with a number of charts, including one of an inflation expectations survey.

So what do things look like today?

This is the historical graph for implied U.S. inflation over the next 5 years, based on TIPS. Remember, you are looking at 5-year inflation expectations as they changed over the last year.

In the dark days of October-December, inflation expectations were clearly negative: that is, the market was expecting deflation over a 5-year period. Things have picked up, but inflation expectations are still around 0.6% - far less than the 1.7-2.0% targeted by the Fed. And that 0.6% is before adjusting for the inflation risk premium, so inflation expectations are actually lower than the chart shows.

And these are current inflation expectations over various time horizons, again derived from inflation-indexed bonds. Note that they are sorted by value, not by time.

TIPS are not very liquid compared to regular Treasury bonds, and the implied inflation expectation numbers are sensitive to aberrations in both the Treasury and the TIPS markets (which have both been pretty aberrant recently). For example, if there is a shortage of TIPS of a given maturity, then the TIPS yields will be artificially low and the implied inflation expectation will be artificially high. Still, it seems like inflation expectations are on the low side, even when it comes to the 10- and 20-year time horizons. (I don’t know what’s going on with the 2-year number: when I look at the underlying bonds, it seems like it should be about -0.1%.)

For more on measuring inflation expectations, there is a short primer from the San Francisco Fed, as well as the Bank of England paper mentioned above.

Comments

[Fighting Yoda:]

There is talk of tax on TIPS and CPI is rigged.

Everything is taxed - have a suitable tax hedging strategy for specific investments.

CPI being rigged - it is the way it is - everything is rigged - entire Wall Street is rigged - analysts/estimates - it all is a giant Ponzi scheme. But that is the system -we are all a part of it and have to make the best out of it. CPI has obvious limitations and flaws - price/quality adjustments (hedonics), home rents are used as factor not home prices, etc etc.

TIPS offer a very good inflation hedge, the current inflation expectations are low - this is not a Govt. created number. These are the expectations of investors - if you think inflation will go higher - bet on it - buy TIPS and make a killing.

Apr 10 03:03 PM

[Tao:]

Doesn't new money replace all the money that disappeared out of equities last year?

Great article.

Apr 10 06:31 PM

[SW Richmond:]

John L,

We shall see. In the meantime, simple math tells me that it makes no sense at all to be paid a small amount of "dollars" for a day's work, when vast quantities of these same "dollars" can be clicked into existence at the whim of one man.

Apr 10 08:14 PM

[THofler:]

The first explanation of TIPs that I think understand completely.
Thanks!

Apr 10 08:18 PM

[Dirk McCoy:]

There are a lot of moving parts here, but a few key facts:

1. A US minimum wage worker can earn a Big Mac in about 20 minutes. A Chinese worker doing similar work nees to work for 2 hours to do the same;

2. Items that are not easily substituted- such as top universities, Manhattan real estate, designer jeans- maintain price power;

3. Minimum wages act as price controls, and in a deflationary environment just mean underutilization (i.e., unemployment);

4. Unemployment around 10 percent would engender a major political upheaval;

5. Anytime the Fed inverts the yield curve with its rate hikes, banks, credit, and the economy suffers;

6. There are three billion people on the planet living on less than $2.50 a day;

7. Substitutionary labor and technology are available to mitigate inflation, but not as quickly accessible as in the past- scale and complexity mean it takes longer time and less uncertainty for this new capacity to come on line;

8. There are energy and water challenges that can be met with very sizable investment- and if not met, their cost will be so overwhelming that it will be obvious that this investment is warranted.

If I put all this in a grinder and turn the wheel, what comes out is this: The Fed will keep rates low (probably a little too long), inflation will heat up, and if they're smart they won't invert the yield curve so that credit will continue to expand. There will be momentary periods of price madness as companies realize new competitors are coming in and make hay while the sun is shining, but if played correctly, a global economic boom could be just over the horizon...

Apr 11 12:02 AM

[Anandakos:]

Tao,

I'm sorry, but I don't buy this widely held opinion. I know it's popular among pro-stimulus economists, but I think they're missing an important point.

It seems pretty obvious to me that the market value of equities is NOT equivalent to "money". It can't circulate. For the owner of a security to utilize that wealth in any way other than an investment, she or he has to sell it to another holder. The original holder now has liquid money to spend as she or he wants, but the new holder has reduced his or her ready funds by the same amount. Thus the amount of circulating money has been unchanged.

Wealth does not equal money. Money is but one special form of wealth.

So, increasing the circulating money supply to "replace" the evanescent wealth evaporated by the meltdown should in fact lead to inflation. Now we may be "lucky" and see that inflation only in the price of the assets propped up. In other words, we may reflate the bubble in assets but not experience rising prices in other areas of the economy. But I'm pretty doubtful that the Fed can pull off that particular legerdemain again.

On Apr 10 06:31 PM Tao wrote:

> Doesn't new money replace all the money that disappeared out of equities
> last year?
>
> Great article.

Apr 12 03:16 AM

[Bill S. Friend:]

Holy smokes my brain hurts!
We have a fiat currency and once everyone in the world learns quadrillion (1,000,000,000,000,000) comes after trillion the hurting will begin. Nobody knows the outcome or the unintended consequences of throwing trillions into the fray.

It is my pleasure to announce the much anticipated New World Currency! As deficits skyrocket and new paper money is printed its nice to know that there is a safety net waiting for the US Dollar. Welcome back to the gold standard friends!

Greenspan advocated a return to the gold standard. I must agree. The Gold Eagle has been minted in the following denominations.

1 ounce: $50 face value
1/2 ounce: $25 face value
1/4 ounce: $10 face value
1/10 ounce: $5 face value
So, your "new" dollar is worth about $17.81 in current paper dollars, or 1/50th of an ounce of gold, at the time of this writing. Conveniently the Silver Eagle has a one dollar face value and assumes the value of silver as 1/50th that of gold. No need to mint new coins in denominations less than a dollar as the current ones will suffice.

This is not a matter of "if" its a matter of "when" this becomes the new accepted form of currency.

Apr 12 09:38 AM

[The Geoffster:]

Yes, we are seeing a massive devaluation of wealth resulting from the bursting of the bubble fueled by cheap debt. As asset values and income streams deflate, that cheap debt can no longer be serviced on its original terms. Hence, that debt must be reduced at the cost of the debt holders. All this is deflationary. To prevent a deflationary spiral, the Fed and the Treasury are engaged in a coordinated strategy to re-inflate the economy by any means possible. This is not new money replacing old. It is new debt. This debt, like the old, can never be repaid in current dollars. It must be monetized. That is the definition of inflation.

Apr 12 10:56 AM

[bearfund:]

(Note: the author misuses "inflation" to mean "broad-based changes in nominal prices". The correct definition is "increase in the supply of money", one of the typical effects of which is such an increase in nominal prices. They are not the same, however. In my comments below I will go along with the author's definition).

Surveys measure something different from breakeven spreads and swaps. In fact, it's hard to know exactly what surveys do measure, but they can capture two things the other metrics cannot: the expectations of those who do not or cannot participate in the mentioned markets, and (potentially) the extent to which those surveyed believe the CPI matches their definition of "inflation".

An additional metric not mentioned here is the gold market, which unfortunately also reflects a number of variables that are neither past inflation nor inflation expectations, but is in the long run probably the only truly accurate measure of *past* inflation. But it too is inadequate. I feel very comfortable using gold to say that today's dollar purchases around 2.5% of what it did in 1920. We can argue whether it's really 2% or 3.3%, but that number is not far wrong. But by the same logic, the dollar buys as much today as it did in 1980 - clearly an absurd conclusion. We can play games with moving averages but the reality is that the gold market harbors a lot of highly leveraged participants, dark pools, and suppliers (central banks) that act perversely with respect to their own profits. It is also subject to nebulous factors like "fear" that can cause price levels to diverge from reality; it is more correct to state that if the gold market is capable of measuring anything at all, it measures momentary confidence in the fiat money and fractional-reserve system. Inflation and inflation expectations are but one component of that confidence, so it will not do for our purposes either.

The trouble is that the CPI-U tells you that today's dollar buys about 47% (CPI-U=212.193 as of 2/09, 1982-4=100) as much as it did around that same time. I will contend that no person who was actually responsible for managing the finances of a household in 1982 and still is so today would afford that figure any credibility whatsoever. That is, while gold contains a huge amount of noise, the CPI-U is much less noisy but contains large systemic errors. Therefore, it's very important to state explicitly that TIPS and swaps measure CPI-U expectations (or expectations of whatever they're indexed to if not the CPI-U), not any useful definition of inflation. Worse, most of these instruments are held by one of two types of entity: large insurers and pension funds with CPI-indexed liabilities, and large banks. In the former case, the investor does not care whether the price accurately reflects either expectations or reality; they are holding to maturity and the proceeds, whatever they are, will suffice for their intended purpose. The banks, of course, are enormously leveraged and actually profit from a decline in the dollar's purchasing power, so a small real loss on a TIPS or a swap becomes a gain against a much larger real loss by the bank's depositors and other creditors.

In short, then, the two markets described are dominated by two factors rendering them of little value for the stated purpose: a dubious index and participants with little or no incentive to ensure that the prices they pay and receive are meaningful indicators of their own inflation expectations. Throw in a hefty helping of illiquidity and we can simply disregard these markets altogether.

So we're left with surveys. These at least attempt to measure expectations of the right people: those for whom the "cost of living" has some meaning and who are likely to hold most or all of their assets in cash over the period of interest (even if only on payday). Unfortunately most of those surveyed do not understand what inflation really is and in most cases do not even have sufficient data to determine whether their past estimates of it were correct, making future estimates nothing more than guesses. It would be more reasonable to simply ask them how rapidly they expect the cost of living to increase in coming years relative to the rate at which it increased in the last N years, and use non-numeric answers (much more slowly or not at all, more slowly, about the same, more rapidly, much more rapidly). Any significant balance toward the latter two should be a strong warning signal to central bankers, regardless of the numbers those surveyed would have assigned if given the chance. But today's surveys are not conducted in this fashion, so we continue to read that 800 randomly-selected adults expect 5-year inflation of 3.2%, a stunning example of precision in the complete absence of accuracy or even context.

A new approach to macro price prediction is needed. Some of the data described here may be valid inputs, but a rigorous many-factor approach with backtesting is required, just as it is for any other technical exercise. I do not know whether such an approach will yield better results than chance would indicate, but it could not be worse than any of the indicators mentioned here.

Apr 12 12:32 PM

[bearfund:]

Correct. Unfortunately, there are still two problems with this approach. First, you cannot expect this to preserve purchasing power unless you believe the CPI-U will accurately reflect your cost of living in the future. Second, Roth accounts provide the greatest benefit when your current tax rate is lower than your rate at the time you take distributions. I would expect, however, that if (when) tax rates are increased significantly, the law will also be changed to apply some sort of "windfall profts" tax on such distributions. It will be a juicy target and a popular one, especially if the date for such a tax is placed far enough in the future that it does not mobilise the gray-and-green voting bloc.

Lilguy is correct about the burden of taxation in general. However, he overlooks the fact that the stream of income from equities, even if it were taxed at the same rate as that from bonds or were held in a Roth, tends to rise with the price of the goods or services the underlying businesses create. This offers you an opportunity to match your future assets and liabilities. In fact, TIPS could even have a place in such a portfolio: some cities have rent control indexed to the CPI-U. But most people's retirement liabilities will not be represented well by that index.

There is no panacea, but I stand by my analysis of TIPS: if Treasuries are "certificates of guaranteed confiscation," then TIPS are simply Treasuries openly stamped with that notation. They are a terrible investment for almost every individual investor. Those looking for inflation hedges should consider almost any other asset class ahead of TIPS: gold and silver (physical, futures, or miners), oil (futures or equities), timberland, farmland, equities generally, commodity-linked ETFs, futures, and producers, etc. Intermediate-term Munis look attractive right now but in the long run they are just bonds and will suffer horribly by the Fed's misguided policies. The only other type of bond I will consider buying is the distressed corporate security with a maturity less than 3 years away, and I do so for the purposes of speculation and/or arbitrage, not to generate retirement income. A lot of investors are having doubts about buy and hold in regard to equities, but whatever the merits of that approach for that asset class, buy and hold for bonds at today's yields is pure unadulterated death. TIPS are really no better than any others, and the tax disadvantages are just another nail in the coffin.

On Apr 10 10:39 AM _richard_ wrote:

> mac.barron: The trick here, of course, is to keep TIPS in a tax-deferred
> vehicle, such as a 401(k) or a Roth-IRA. Also, each individual is
> permitted $10,000 per year in savings bond purchases ($5,000 paper,
> $5,000 online) and the I-bond savings bond is an inflation adjusted
> bond with interest due when the bond is cashed in (up to 30 years
> in the future). If such bonds are bought when an individual is subject
> to a high marginal rate and sold when subject to a low marginal rate,
> the actual reduction is somewhat less.

Apr 12 12:56 PM

[ps55:]

Should be interesting to see the real effect that this will have on the dollar. Right now it is distorted by psychological factors such as risk aversion and global worries. When the dust settles, I imagine the the interest rate environment will come back into play, and combined with inflation the dollar should weaken tremendously. Currency traders at marketfriends.com looking for US dollar weakness across the board, especially if global markets are bottoming and/or rebounding here

Apr 12 01:16 PM

[six:]

Ignore all predictions of inflation (defined as the rise of the cost of goods and services). The money that the government is printing only matters if someone is spending it- the money is not chasing goods it is not spurring price increases. The American consumer has stopped spending in a reckless manner. The velocity of money has slowed to crawl. Trillions of dollars have been removed from the economy from the decline of real estate values (no more HELOC ATMS) and banks cutting back on credit available to borrowers. The money that the US gov is printing is nothing in comparison to the disappearance of the aforementioned wealth. As the economy slows there are signs of deflation, wages are being cut in unlikely professions- the State of Deleware cut wages by 8% accross the board. Less money being made MUST result in less money being spent. How can asset prices rise in such a situation? They can not. In fact, they have to fall thus deflation.
The situation is similar to pre 2006 when real estate prices skyrocketed and the gov told us inflation was low. Today those real estate prices are crashing and they are telling us we are seeing normal inflation. Neither makes any sense when you stop and think about it. Whatever happens to the price of largest asset that most Americans will own in their lifetime is endemic to the rest of the economy. Especially when you consider that the homeower is the primary driver of the consumer economy. There will be no recovery in the market or the economy has a whole until real estate finds a bottom. That is not something certain to happen in 2009, 2010 is possible but it could last in 2011. When the bottom is formed, do we see a recovery to the economy of 2006? That hardly seems likely. Growth will likely be much more moderate and not based upon the pie in the sky increase in the value of assets such as stocks or real estate. Credit markets will never be the same, lending money to anyone with a pulse. The growth of asset values will be moderate but much more stable. None of the indicators point to inflation of prices but the technical definition of the increase in the supply of money.

Apr 12 01:34 PM

[tom Andersen:]

All of the underwater mortgages and the national debt will be manageable if prices double. This then becomes the central goal of US monetary policy. Americans are not like the Japanese, they will not stand around and wait it out. So inflation will come sooner rather then later, doubling all prices and then likely go away again. Based on this, gold will go from $1k to $2k in price, but when gold starts rising, there will be at least a bit of a rush for it, so the real value of it will also double - expect $3k to $4k gold within 2 - 3 years. Inflation is required to pull the US out of debt, and I know that American business owners and government do NOT sit around and 'take it' - they take action.

Apr 12 10:14 PM

[MGA_1:]

inflation = increase in the supply of money. Either through direct operations of the fed or fractional reserve lending by banks.
deflation = decrease in the supply of money. Either through direct operations of the fed, or default on loans.

We were in a deflationary downtrend through '08 and it looks like part of '09. It looks to me like reflationary/inflationary for the future. Couple things to look at:
* Is the fed going to have to directly purchase t bills to support the future govt debt?
* Are foreigners going to give up on the US and sell their t bill holdings?
* How much more is the fed going to recapatilalize the banks? 800 billion so far with fannie/freddie. I personally think the fed it going to make an attempt to save the US housing market... there will be plenty money given to banks.

So, I predict future inflation. Although *asset* prices have gone down substantially (stocks, real estate), I haven't noticed any real prices drops in restaurants and groceries which is interesting. I think reflation/inflation will hit these sectors next.

Apr 12 11:25 PM

[MarvinMBA:]

Certainly business one o one tells us that there is no such thing as a free lunch. This applies to the Treasury also. Looking for T bonds to drop significantly pricking another bubble. MarvinMBA

Apr 12 11:44 PM

[mrbill:]

Here's my version of what you just said:

(DON'T) Ignore all predictions of inflation (defined as the rise of the cost of goods and services). The money that the government is printing only matters if someone is spending it (LIKE CHINA)- the money is not chasing goods (BY AMERICAN CONSUMERS) it is not spurring price increases (AS LONG AS CHINA IS NOT BUYING LOTS OF THINGS LIKE BASIC MATERIALS, BUT THEY ARE). The American consumer has stopped spending in a reckless manner (BUT CHINA WILL SPEND AND MAKE UP THE DIFFERENCE). The velocity of money has slowed to crawl (BUT CHINA'S SPENDING IS PICKING UP PACE). Trillions of dollars have been removed from the economy (THOUGH CHINA IS MORE THAN WILLING TO PUT IT BACK IN) from the decline of real estate values (no more HELOC ATMS) and banks cutting back on credit available to borrowers.



On Apr 12 01:34 PM six wrote:

> Ignore all predictions of inflation (defined as the rise of the cost
> of goods and services). The money that the government is printing
> only matters if someone is spending it- the money is not chasing
> goods it is not spurring price increases. The American consumer
> has stopped spending in a reckless manner. The velocity of money
> has slowed to crawl. Trillions of dollars have been removed from
> the economy from the decline of real estate values (no more HELOC
> ATMS) and banks cutting back on credit available to borrowers. The
> money that the US gov is printing is nothing in comparison to the
> disappearance of the aforementioned wealth. As the economy slows
> there are signs of deflation, wages are being cut in unlikely professions-
> the State of Deleware cut wages by 8% accross the board. Less money
> being made MUST result in less money being spent. How can asset
> prices rise in such a situation? They can not. In fact, they have
> to fall thus deflation.
> The situation is similar to pre 2006 when real estate prices skyrocketed
> and the gov told us inflation was low. Today those real estate prices
> are crashing and they are telling us we are seeing normal inflation.
> Neither makes any sense when you stop and think about it. Whatever
> happens to the price of largest asset that most Americans will own
> in their lifetime is endemic to the rest of the economy. Especially
> when you consider that the homeower is the primary driver of the
> consumer economy. There will be no recovery in the market or the
> economy has a whole until real estate finds a bottom. That is not
> something certain to happen in 2009, 2010 is possible but it could
> last in 2011. When the bottom is formed, do we see a recovery to
> the economy of 2006? That hardly seems likely. Growth will likely
> be much more moderate and not based upon the pie in the sky increase
> in the value of assets such as stocks or real estate. Credit markets
> will never be the same, lending money to anyone with a pulse. The
> growth of asset values will be moderate but much more stable. None
> of the indicators point to inflation of prices but the technical
> definition of the increase in the supply of money.

Apr 12 11:45 PM

[hatarakiman:]

The inflation is already happening in the Treasury asset class. We deflate stocks, housings, and commodities, but inflate the treasury at the same period of time.
From the big Mac index or CommSec iPod index, we know which area has inflation or deflation tendency compared to US.
So far I am not worried about the delation in Japan, I am more concerned about the inflation in China. The same in the housing market, you care more about the one who is going to bid on the house you want to buy.
According to the auto sales data in China, the oil price will not stay low for too long.
There are 7 trillions in the money market and saving account, and Fed is printing money by buying long term bond and Agency bonds. Once people are getting used to the great depression hoax, the consumers will restore their consumption behaviors.

Apr 13 05:57 AM

[Chris B:]

1) Regarding the definition of inflation: sorry, but the dictionary definition is an aggregate increases in prices. This can occur due to a reduction in the scarcity of money or due to an increase in the scarcity of goods and services (or both). An increase in the money supply is called an increase in the money supply. Various measures such as M1, M2, and velocity are applied to study money supply. They are very separate concepts.

2) Regarding the CPI controversy: The methods used to calculate CPI have been scrutinized for decades, and are transparently published on the treasury's website for your review. An enormous amount of real-world price research by thousands of people occurs each time it is calculated. It is far less "invented" than many of the opinions offered as substitutes. Does it measure increases/decreases in YOUR cost of living? Absolutely not. If you want to measure changes in your cost of living, just review your checking account while excluding any upgrades. CPI / PPI are aggregate statistics. To the extent that your particular expenses differ from the mean, changes in your personal expenses may differ from CPI. For example, if you eat bananas 3 times a day, you are more affected than the typical consumer to changes in banana prices. It would be nearly impossible to calculate a personal inflation rate for every individual in the country, so it's carefully done in aggregate. This is true of any price measure.

3) The discussion on TIPS misses an important point. Namely, that many TIPS buyers are not interested in holding to maturity. Rather, they are buying an option on an increase in inflation, and plan to resell their TIPS before maturity at a fat profit when even mild inflation returns. Pop quiz: if the future rate of return on a 100% safe 10 year bond suddenly increases from 2% to 5% while newly issued bonds still yield 2%, by how much does the bond increase in value? If you answered 3%, you have no understanding of open market bond pricing. The resale value (or present value) increases a lot faster than the interest rate increases. The mandatory adjustible yields on TIPS offer investors an opportunity to take advantage of exactly this type of situation and earn 2-3 year returns that do much more than outpace inflation.

A rise to a mere 3% inflation rate would give TIPS holders a massive increase in PV and the upside only increases from there. Use an online PV bond calculator to see what I mean.

The downside is the risk of new bonds being issued at higher rates.

Apr 13 01:31 PM

[The Geoffster:]

Likely?
www.bloomberg.com/apps...

Apr 13 03:46 PM

[The Last Bo...:]

Why should I believe that markets are capable of pricing correctly anything, future inflation including. Did the markets get right the house prices from 1998 to 2006? Did they get right the price of the CDS, MBS, or any derivatives? It looks like economists are just absolutely incapable to accept that markets are not always efficient, and may be they are very rarely efficient at pricing correctly anything. So, why should I trust that markets get it this time right at predicting accurately the inflation even tomorrow, and how about 30 years from now?

Apr 13 10:47 PM