Recent news items have noted the fears of several individuals that QE2 will spark rapid inflation, e.g. . For instance, Representative Paul Ryan, expected to become the Chairman of the House Budget Committee in January, stated: “I think it’s going to give us a big inflation problem down the road.”
Here are what various market-based indicators suggest.
First, I show the daily observations on the break even rates for TIPS (and hence the expected inflation rates, under certain assumptions):
Figure 1: Difference between 10 year constant maturity Treasury yields and corresponding TIPS yields (blue), and difference at 5 year constant maturity (red), daily frequency. Source: FRED II, and author’s calculations.
Notice that, like the value of the dollar, there has been some movement over time as market participants ascribed a higher and higher likelihood of a QE2. That is, inflation expectations have trended higher.
However, these movements have to be put into context. If the expectations hypothesis of the term structure (EHTS) holds, then these movements imply that as of 11/8, the average inflation rate over the next five years will be a breathtaking 1.6%! Further, it is useful to place these expected inflation rates in temporal perspective. Figure 2 depicts these same series, on a monthly basis, since 2003 (when the constant maturity series for the TIPS begins).
Figure 2: Difference between 10 year constant maturity Treasury yields and corresponding TIPS yields (blue), and difference at 5 year constant maturity (red). NBER recession dates shaded gray. Source: FRED II, NBER, and author’s calculations.
Expected average inflation over the next five years is still below the rates implied over the entire 2004-2007 period.
As many observers have noted, the simple EHTS probably does not hold; there is likely an inflation-based risk premium which rises with maturity of the instrument. Hence, one would like to control for this effect. The Cleveland Fed has attempted to make this adjustment, combined with a model based measure of inflation based upon surveys and inflation swaps  . The latest estimates are from mid-October, here:
Figure from Cleveland Fed, accessed 11/11/10.
In other words, the market-based indicators do not suggest a burst of substantially higher inflation is imminent. Of course, even under the rational expectations hypothesis, big errors can occur (rat-ex only implies the t+i i > 0 errors are unpredictable based on time t information).
I don’t have survey based measures of expected inflation dated after QE2 became likely. In Figure 3, I show data up to the August Survey of Professional Forecasters (new forecasts will be released next week).
Figure 3: Median expected 10 year CPI inflation (blue) and 1 year CPI inflation (purple). recession dates shaded gray. Quarterly observations pertain to mid-quarter month. Source Philadelphia Fed Survey of Professional Forecasters, NBER, and author’s calculations.
Note that none of the above rely explicitly upon a macro model — that is, I’m not appealing to a Phillips curve to make predictions of inflation (and hence am not directly relying upon the current output gap of between -3 to -6 percentage points of GDP).
Figure 5: Output gap for the United States, from IMF, CBO, and OECD. Gray shaded areas denote forecasts. Source: IMF, World Economic Outlook (October 2010), CBO (May 2010), and OECD Economic Outlook (May 2010).
See also Jim’s take on the impact on both inflation, and relative prices.