Inflation Expectations Diverge

Every month with the release CPI release I do an ‘inflation day post’. This month I missed out on the coverage of the Cleveland Fed inflation expectations curve, but better late than never!

The charts show that inflation expectations year after year have been going down for all maturities. That remains true comparing last month´s to this month´s curve. I would have thought that the greater optimism that lately has pervaded comments and analysis and that is reflected in stock market behavior, for example, would have ‘bumped up’ inflation expectations. Apparently not.

Infla Exp Divergence_1


Infla Exp Divergence_2

So I decided to compare the Cleveland Fed inflation expectations (5 & 10 years) to the 5 and 10 year TIPS spread. This is what transpired.

Infla Exp Divergence_3

The TIPS spread measure of inflation expectations is much more ‘sensitive’ than the Cleveland Fed´s calculation, but what I was looking for is to see if they tell the same ‘story’. Note that they both go up after QE0 at the end of 2008, when it became clear that the Fed would not let the financial system ‘go broke’. In March 09 QE1 is implemented and both measures of expectations, for the medium and long term, keep going up. They reverse trend when QE1 ends in March 10. They react positively to hints of QE2 in late August 10 but come down again after April 11 when the Fed confirmed the end of QE2 scheduled for June 11.

The divergence between the two measures of inflation expectations follows the launch of ‘Operation Twist’ in September 2011. While long term inflation expectations derived from the TIPS spread go on a rising trend that remains even now, following QE3 in September 12 (and QE3 cum thresholds in November) 10 year inflation expectations from the Cleveland Fed remain ‘flat’ and then notch down a step last May.

The divergence is not so great for the medium term measure of inflation expectations, but it is still visible in the data.

Operation Twist´s purpose was to affect the term structure of rates, hopefully lowering longer term rates. Maybe the divergence reflects technical aspects of the Cleveland Fed measure impacted by the policy. For those with a technical bent the Cleveland Fed methodology  is described here.

Or maybe it´s something else. Any ideas?

3 thoughts on “Inflation Expectations Diverge

  1. The paper describing the methodology for the Cleveland Fed’s expectations is dated March 2011 and adds some components, like zero-coupon inflation swaps and yields of normal bonds for example. So if we suppose that it was put into practice some time in 2Q or 3Q, that might explain why it stops tracking TIPS so tightly as that appears to be when the two measures start to go their separate ways. I have no opinion on which measure is more accurate, except for this that I found in the Cleveland Fed paper leads me to believe it might need some looking over: ” … interest rates measure… the tightness of monetary policy…” Nowhere does it mention NGDP growth and it claims that TIPS were grossly under priced in late 2008-09. I think the only way one would believe that is if under the assumption that the Fed and nothing to do with the “crash.”

  2. I’m pretty sure I know the answer, came across it by accident when reading Jeremy Grantham’s hedge fund letters. Look at the last page at

    What is so interesting here is not so much the data itself, as the role that institutional view points play in valuing these assets. The TIPS implied inflation rate is a valuable economic indicator only for as long as people are trading it based purely on its own merits. However, because of the valuable risk characteristics of TIPS compared to other bonds and equities, they have become valuable enough for diversification that it is sensible enough to buy them even if you expect a negative real yield compared to nominal treasuries. This translates into forcing the implied inflation rate up.

    Maybe I should explain more. There is a concept of risk parity, a Hedge fund works out the expected risk adjusted returns for a strategy, and then levers it up to have the same risk as all its other strategies. Thus, if you can lower the risk, even if you lower the real returns, you might get a higher return after you lever up. TIPS negative correlation with many other assets provide exactly this opportunity.

    Thus, I no longer think that TIPS are giving an inflation prediction.

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