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A persistent and crucial economic question is and always will be: What will inflation be in the future? There is no foolproof method of knowing, but as we have highlighted in previous columns, there are indicators that give insights. Our favorite is the TIPS spread.
In 1997, the U.S. Treasury started offering the public Treasury Inflation Protected Securities. These are U.S. government bonds indexed to the standard measure of inflation: the consumer price index. Invest $10,000 in a five-year TIPS today, and if the CPI rises 20% over the period, the bond’s payout at maturity will be $12,000.
Although the ostensible purpose of TIPS is to provide investors/savers with an inflation-proof security, TIPS also provides the public with information about inflation expectations. The difference in the rate of return on a U.S. Treasury-backed TIPS bond and the rate of return on a non-inflation-indexed Treasury bond of identical duration is a well-regarded measure of the financial market’s expectations about inflation. The St. Louis Federal Reserve reports the spread daily.
As of this writing, the five-year TIPS measure of expected inflation was at 2.16% and has been below 2.2% since the end of May. The most recent inflation report gave a year-to-year measure of inflation at 4%. The year-to-year measure of inflation peaked last June at 9.1%, while the five-year TIPS measure of expected inflation was at its highest at 3.59% on March 25 of last year. These latest numbers are good news for at least two reasons.
First, the Fed’s efforts to lower inflation are working. Inflation is down due to the Fed rate hikes, and expectations about future inflation have also declined. Second, expectations are approaching the 2% inflation target to which the Federal Reserve has committed. Fed credibility is perhaps the most important long-term goal of monetary policy. And with some luck, the economy might be able to avoid a recession. Additional interest rate hikes beyond those already expected might not be necessary to tame inflation.
Market prices, like those embedded in the TIPS spread, are indicators of “human origin but not of human design.” No single individual, entity or institution sets the spread, but instead, it reflects the interaction of thousands of market participants seeking their own gain based on the best information they have. The resulting prices reflect a “social consensus” that no focus group or committee of experts could derive. Infallible? No—but a powerful and neutral tool.•
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Bohanon and Horowitz are professors of economics at Ball State University. Send comments to ibjedit@ibj.com.
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