The five year Treasury-TIPS spread has, inarguably, shot up:
Figure 1: Five year inflation breakeven calculated as five year Treasury yield minus five year TIPS yield (blue), five year breakeven adjusted by inflation risk premium and liquidity premium per DKW (red), all in %. NBER defined recession dates shaded gray (from beginning of peak month to end of trough month). Source: FRB via FRED, Treasury, KWW following D’amico, Kim and Wei (DKW) accessed 10/7, NBER and author’s calculations.
What to make of this development?
The gap between the unadjusted and adjusted spreads was 0.44 ppts as of 9/30. If that gap — the combination of inflation risk and liquidity premia — had stayed the same, the implied inflation rate would be 2.5% over the next five years. (Of course, there’s no particular reason why the composite premium would have stayed constant…)
Analysts often look at the the five year five year forward as an indicator of inflation over the five years five years from now. If one applies the same logic about premia to the usual calculation, then one obtains Figure 2.
Figure 2: Five year five year forward spread (blue), five year five year forward spread calculated using inflation risk premium and liquidity premium per DKW (red), all in %. NBER defined recession dates shaded gray (from beginning of peak month to end of trough month). Source: FRB via FRED, Treasury, KWW following D’amico, Kim and Wei (DKW) accessed 10/7, NBER and author’s calculations.
- The “adjusted” spread requires estimating inflation risk and liquidity premia, so one might worry about all sorts of errors being introduced. For what it’s worth, the adjusted spread forecasts actual inflation better than the unadjusted does (although the sample is small), as discussed in this post with an exchange with Joseph E. Gagnon and Madi Sarsenbayev of the Peterson Institute.
- The spread predicts CPI inflation. The Fed pays attention to the PCE deflator. Over the last 35 years, CPI inflation has averaged about 0.43 ppts more than PCE inflation.
If one believed in the DKW adjustment (and that adjustment held constant over the past four weeks), and the gap between CPI and PCE inflation remains roughly constant, that would place average PCE inflation over the next five years at about … 2%.
The five year five year forward, which is often taken as long term CPI inflation, is then 2.3%; implied PCE inflation is then 1.9%…