Econbrowser‘s Menzie Chinn wrote a recent post asking everybody to take a deep breath and calm down a little about inflation, titled High Anxiety (about Interest and Inflation Rates):
Of course, the United States in 2009 is different than Japan in 2001. One key difference is that Japan was, and remains, a net creditor. America is a big net debtor to the rest of the world, with extremely large holdings of US Treasurys by foreign private and state actors. And so, for me, I worry more about higher real interest rates (portfolio balance effects) than higher inflation. But even here, real yields according to TIPS seems fairly low in historical perspective (and roughly comparable to those prevailing during the period characterized as “the saving glut”).
My bottom line: Think, and recollect, before panicking.
In the post, he referenced a paper by Stefania D’Amico, Don H. Kim and Min Wei (all of the Fed’s Division of Monetary Affairs), Tips from TIPS: The Informational Content of Treasury Inflation-Protected Security Prices:
We examine the informational content of TIPS yields from the viewpoint of a general 3-factor no-arbitrage term structure model of inflation and interest rates. Our empirical results indicate that TIPS yields contained a “liquidity premium” that was until recently quite large (~ 1%). Key features of this premium are difficult to account for in a rational pricing framework, suggesting that TIPS may not have been priced efficiently in its early years. Besides the liquidity premium, a time-varying inflation risk premium complicates the interpretation of the TIPS breakeven inflation rate (the difference between the nominal and TIPS yields). Nonetheless, high-frequency variation in the TIPS breakeven rates is similar to the variation in inflation expectations implied by the model, lending support to the view that TIPS breakeven inflation rates are a useful proxy for inflation expectations.
This paper was cited by Grishenko & Huang (which has been discussed on PrefBlog), who emphasize:
In a related study, the long-run averages of inflation risk premium in D’Amico, Kim, and Wei (2006) can be positive or negative depending on the different series that they use to fit the three-factor term-structure model.
Footnote: See Figures 4 through 6 in their paper.
Back to D’Amico et al.:
Specifically, we model the dynamics of nominal yields, inflation, and TIPS yields in a general no-arbitrage term structure model setting, and examine the extent to which these data are consistent with each other. Furthermore, we seek to establish some basic facts about the real term structure and the inflation risk premia implicit in nominal bond yields and to obtain an estimate of the “liquidity premium” in TIPS yields.
…
Our main results can be summarized as follows. In all the cases that we have examined, estimating the model taking TIPS yields at their face value fails to produce plausible estimates of inflation expectations or inflation risk premia. The difference between the observed TIPS yields and the model-implied real yields estimated without TIPS data indicates that the “liquidity premium” was quite large in the early years of TIPS’s existence, but has become smaller recently. This liquidity premium turns out to be difficult to account for within a simple rational pricing framework, suggesting that TIPS may not have been priced efficiently in their early years. Nonetheless, time variation in TIPS-based and model-implied breakeven rates are quite similar, suggesting that changes in the TIPS breakeven rates largely reflects changes in inflation expectations or in the investors’ attitude toward inflation risks, rather than being random movements.
They conclude:
The answer to the question of whether the TIPS breakeven rate can be taken as inflation expectation is more complicated. We find that the weekly changes in the model-implied 10-year inflation expectation tend to line up with the weekly changes in the 10-year TIPS breakeven rate. However, we also find that time variation in the inflation risk premium and the TIPS liquidity premium, the latter of which may also include other unaccounted-for effects, are often significant enough to drive a wedge between the qualitative behavior of the breakeven rates and inflation expectations. Our findings in this paper provide support for the use of TIPS breakeven rate information as a proxy for inflation expectations, but also provide a justification for caution. Indeed, in speeches that touch on inflation, policy makers often refer to the TIPS breakeven rate, but they also recognize that the interpretation of this measure is complicated by inflation risk premia and liquidity issues and then continue to monitor a large number of variables to gauge inflation expectations and underlying inflation pressures. More data and more work on TIPS modeling in the future will ndoubtedly shed more light on the informational content of TIPS prices.