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Wednesday, April 13, 2011

How to Calculate Expected Inflation

Inflation expectations affect markets. Analysts scramble to find stocks with pricing power, investors sell fixed rate bonds, and consumers borrow to the hilt when expectations change.  Commentators make all kinds of predictions and debate the impact of Federal Reserve policies. When inflation worries start to rise, investors sense it; but how can expectations be measured more precisely?

Source:Bloomberg
Actually it is quite easy. Go to Bloomberg and the drop down list at "Market Data."  Click "Rates & Bonds". You'll see the rate on the 10-year U.S. Treasury note. Today it was 3.52%. CLICK TO ENLARGE.



Source: Bloomberg
Next scroll down on the Bloomberg page to the 10-year Treasury TIP (Treasury Inflation Protected Treasury note).  You'll see the yield is 0.87%. CLICK TO ENLARGE

To calculate the expected rate of inflation, just subtract the TIP rate from the 10-year Treasury note rate:  3.52 - 0.87 = 2.65%.

Why does this work? If the rate of inflation exceeds 2.65%, then investors will do better in the TIP note rather than the regular issue. This is because the principal amount of the TIP is adjusted by the rate of inflation.

By doing this calculation once/week or so, the DIY investor will get a feel for how inflation expectations are changing.

7 comments:

  1. Very nice "how-to" post. I also follow the breakeven inflation rate closely, and I think your point about watching how expectations are changing is a good one.

    I believe that understanding how this metric is evolving over time is even more important than the particular level at any given moment. 2.65% and rising is more concerning than 2.65% and falling.

    ReplyDelete
  2. @Chad I agree that tracking how it is changing over time is more important than the level.

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  3. Very clever and an awesome tip!

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  4. The difference between the treasury and the TIPs rate is an approximate measure of expected inflation.
    The more precise number is obtained as follows:
    Expected inflation rate = ((1+Nominal Treasury Rate) /(1 + TIPs rate))-1

    ReplyDelete
    Replies
    1. That is true too...also, the yields on TIPS is also a function of liquidity and investor demand, so that in itself is not a perfect proxy either

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  5. Can you tell how I can calculate the quarterly expected inflation for Romania please?

    ReplyDelete