A New Approach to Gauging Inflation Expectations

This Economic Commentary explains a relatively new method of uncovering inflation expectations, real interest rates, and an inflation-risk premium. It provides estimates of expected inflation from one month to 30 years, an estimate of the inflation-risk premium, and a measure of real interest rates, particularly a short (one-month) rate, which is not readily available from the TIPS market. Calculations using the method suggest that longer-term inflation expectations remain near historic lows. Furthermore, the inflation-risk premium is also low, which in the model means that inflation is not expected to deviate far from expectations. Policymakers at the Federal Reserve and other central banks continually face the "Goldilocks" question- is monetary policy too tight, too loose, or just right? It would help if the central bank knew what real interest rates and expected inflation actually were, but these are not easy to observe. Visible indicators of these factors, such as Treasury inflation-protected securities (TIPS), survey measures of expected inflation, and nominal interest rates, are useful, but none of them alone quite tells the whole story. Nominal interest rates change with boda real rates and expected inflation, survey measures ask about only a few horizons, and measures of inflation expectations coming from inflationprotected securities conflate expectations with risk premia. Uncovering a purer measure is possible, but it takes a careful combination of the available data and the application of economic theory.
This Economic Commentary explains a relatively new method of uncovering inflation expectations and real interest rates and describes what light those numbers can shed on die current status of die U.S. economy. People's expectation of inflation enters into nearly every economic decision they make. It enters into large decisions: whedier they can afford a mortgage payment on a new house, whether they strike for higher wages, how they invest their retirement funds. It also enters into the smaller decisions, that, in the aggregate, affect the entire economy: whedier they wait for die milk to go on sale or buy it before die price goes up.
Real interest rates also play a key role in many economic decisions. When businesses invest- or don't- in plants and equipment, when families buy- or don't- a new car or dishwasher, they are making judgments about die real return on die object and die real cost of borrowing. As such, real interest rates can be an important guide to monetary policy. As Alan Greenspan once explained,1 keeping the real rate around its equilibrium level (which is determined by economic and financial conditions), has a "stabilizing effect on die economy" and it helps direct production "toward its long-term potential."
Modeling Interest Rates
For economists, a model is not a toy train or runway star, but radier, a simplified description of reality, usually involving equations. It's a way to describe how die parts of die world (or at least die financial markets) fit together. Our new approach to estimating inflation expectations starts with a model of real and nominal interest rates- in effect making assumptions and writing down equations diat purport to describe how interest rates and inflation move over time.2 The model has two key parts. The first describes how short-term real interest rates and inflation move over time. The model has to capture movements of short-term rates accurately in order to describe die behavior of all interest rates accurately: if short-term rates rise, do they stay high or quickly fall; do they move smoodily or take a few big jumps? The second part of die model describes how those movements in shortterm rates and inflation build up and determine longer-term interest rates and expectations.
Economists think longer-term rates such as 10-year bonds are tied to shorter rates in two ways, and the model reflects both. The first and most influential determinant of longterm rates is market expectations of future short rates. Investing in a two-year bond is a lot like investing in two one-year bonds back to back: one now and another one a year later. The yields shouldn't get too far out of line. But because those two investments are not quite identical, longterm rates are also determined in part by something else. Because of risk, because investors don't know what rates will be next year- longer-term bonds embed a term premium in their rates, a risk factor that makes long-term rates different from the average of expected future short rates.
This means that the model also has to describe how investors incorporate risk into interest rates. This has two parts. One has to do with capturing the amount of risk perceived to exist, which is in effect, capturing how variable short-term rates and inflation are, and the other has to do with estimating the prices of those risks. These considerations introduce several new factors into the model, including separate variability measures for inflation and interest rates, and, because investors might feel differendy about variability in interest rates and inflation, separate prices of risk.