A Brief Introduction to Inflation
Modern economics suggests that expectations for inflation are an important factor in the determination of actual/realized inflation. Based on past experience and whatever future outlook they have at their disposal households and firms will decide on the likely future of prices and incorporate that into how they negotiate wages and price products.
Neoclassical economics states that inflation and inflation expectations begin with workers and acts initially through the setting of wages. If the economy is healthy, growth is stable, and unemployment is low then workers realize that they are not easily substituted and can request increased wages from employers. A simple way to think about how employers/businesses set prices is this: businesses have a set of costs that go into making a product (energy, labor, materials, marketing, etc.). Based on this set of costs they then charge a “markup” for their services which establishes their profit margin. Employers are profit maximizers and are loath to accept an increased cost of wages, as such they will try and pass part (or all) of this cost onto consumers through the markup. Competition will moderate the degree to which they can increase prices, but if there is a labor shortage across the industry then their competitors are likely taking similar action. Thus, you observe a general increase in wages and the price of products.
This description is obviously stylized but provides a plausible mechanism through which prices adjust and inflation increases. Historically, rapid inflation has occurred for many other reasons than wage increases. In fact, wage based inflation is probably the most benign form of inflation we can imagine. In the 1970’s a combination of overly loose monetary policy and oil price shocks created a violent wave of inflation that lasted a decade and has been on the decline ever since.
As the below graph illustrates, inflation has been much more stable in recent times and today the problem seems to be too little inflation rather than too much.
So how do we measure inflation expectations? If you’re like most people, then you probably don’t have a good model for how prices will adjust in the future (most economists don’t either). So, given the lack of knowledge or a suitable model we have to turn to sources in the real world to gauge expectations for inflation. This is where the notion of breakeven inflation will come into play.
Inflation Expectations and Breakeven Inflation
There are essentially two ways to measure inflation expectations: 1) survey-based methods, and 2) market-based methods. Economists tend to favor market-based methods for the simple reason that money is on the line. In a survey you can claim that you expect 2% inflation in the year ahead, but if bets you place in the bond markets really point to 4% inflation then you might have some explaining to do.
The most common method for assessing market expectations of inflation is to look at the difference between the yield on Treasury Bonds and yield on Treasury Inflation-Protected Securities (TIPS) of similar maturities.
A quick review of TIPS might be in order if you haven’t dealt with them before.
Treasury Inflation Protected Securities (TIPS)
TIPS are a form of debt issued by the government. In exchange for cash up front, the government promises to make periodic interest payments for a set number of years and return principle at maturity. What differentiates TIPS from T-Bonds or Bills is that the interest and principle is indexed to inflation; i.e. the Treasury automatically adjusts the periodic interest and principle payments to account for changes in prices (inflation) so that your buying power is kept constant.
For example, if you purchase a $1,000 T-Bond in 2020 with an annual coupon (i.e. interest payment) of 5% then you can expect to receive $50 each year and $1000 at maturity. If, however, inflation in 2021 is 10% then that $50 payment doesn’t buy you the same amount of goods as it did the previous year. If instead you had purchased a $1,000 TIPS paying 5%, then that $50 coupon would automatically increase to $55 so that you could buy the same $50 worth of goods in 2020 dollars; your purchasing power is protected.
Sounds like a pretty good deal, right? Well, market participants realize this and consequently you often end up paying more for that TIPS up-front then you would for a similar T-Bond. In effect, you pay an additional premium to ensure your purchasing power is protected.
What does all of this have to do with inflation? Well, since TIPS payments are protected from inflation whereas T-Bonds are not we can use the difference in yield to determine market participants’ views on the future path of inflation.
Breakeven Inflation
The basic formula to calculate Breakeven Inflation is as follows:
Break-even Inflation = Treasury Yield – TIPS Yield
The reason this is called Break-even Inflation is because it represents the level of inflation required to make you indifferent between investing in a T-Bond versus a TIPS; you “breakeven”.
This simple formula tells us how the market views future inflation. If market participants are willing to pay a high premium on a TIPS to have their interest and principle protected, then we can infer that they expect inflation to be higher in the future. If, however, they are unwilling to pay a premium or no premium at all then we can infer that expectations for inflation are pretty benign.
Let’s bring all of this together with an example. Below I have two hypothetical Treasury notes, one is a 5-year T-Bond that pays a 5% annual coupon and is trading at its par value of $1,000. The other is 5-year TIPS that also pays a 5% coupon but is trading at a premium to its $1,000 par value. To keep this simple, let’s assume actual inflation is 2% but market participants aren’t aware of this ahead of time.
The valuation of the Treasury Bond is simple. The Bond is trading at par and paying a 5% coupon. Annually the investor receives $50 and at maturity they also receive back the $1,000 par value of the bond. This implies a yield-to-maturity of 5% which you see highlighted in green. If we discount the cash flows back at 1 + YTM then we can recover the price of the bond which you see highlighted in light blue.
The TIPS cash flows become slightly more complicated, but the concept remains the same. Because the cash flows are inflation protected the bond sells at a premium to its par value (market price $1,195, par value $1,000). The coupon payments each year increase by inflation as does the principle when it is returned in Year 5. This calculation is presented below.
- Year 1: 1000 x .05 x 1.02 = 51.00
- Year 2: 1000 x .05 x 1.022 = 52.02
- Year 3: 1000 x .05 x 1.023 = 53.06
- Year 4: 1000 x .05 x 1.024 = 54.12
- Year 5: 1000 x .05 x 1.025 + 1000 x 1.025 = 1,159.28
The yield to maturity on the TIPS is 3% which you also see highlighted in green. If we discount the cash flows back at 1 + YTM then we are able to recover the market price of the bonds, again highlighted in light blue.
This is the crux of the inflation expectations calculation. By examining Treasury Bond and TIPS prices in the marketplace and calculating the yield to maturity we can infer the market’s outlook on inflation in the coming years.
Breakeven Inflation = Yield on Treasury Bond – Yield on TIPS = 5% – 3% = 2%
Here we calculate the breakeven inflation to be 2% which is exactly what we would expect!
To wrap up the concept of “breakeven” let’s quickly examine the returns for these bonds over the 5-year period. For the T-Bond the return is approximately 5% per year in nominal terms. Each year that 5% return is a little less useful to you because it gets eroded by inflation. In order to make an apples to apples comparison we need to adjust the nominal return by inflation to obtain the real or inflation adjusted return on the T-Bond. We do this as follows:
- Year 1: 50 / 1000 = 5% / 1.021 = 4.90%
- Year 2: 50 / 1000 = 5% / 1.022 = 4.81%
- Year 3: 50 / 1000 = 5% / 1.023 = 4.71%
- Year 4: 50 / 1000 = 5% / 1.024 = 4.62%
- Year 5: 1050 / 1000 = 105% / 1.025 = 95.10%
If we add up the single period returns and subtract 1 (because part of the “return” in Year 5 is just return of principle) then we obtain a real total return of 14.1% which you see highlighted in yellow.
We can do a similar procedure for the TIPS, but this time, because the cash flows are inflation protected the return calculation is already given in real terms; we don’t need to make any further adjustments. The real return on the TIPS is 14.6% again highlighted in yellow.
This brings us back to the concept of Breakeven. When described in real terms we observe that the total return of the T-Bond and TIPS is very similar. All else equal you’d be basically indifferent between investing in the T-Bond and TIPS if you expected inflation over the next 5 years to average 2%. Of course, if you expected inflation to be higher than 2% (for whatever reason) then you would prefer the TIPS and the T-Bond otherwise.
Inflation expectations and breakevens are generally calculated on a 5, 10- and 30-year basis for the simple reason that maturities for both T-Bonds and TIPS exist for each of those vintages and all are traded widely in the market. Let’s look at the yields on 10-year T-Bonds, TIPS and breakevens to see how expectations for inflation have changed over time. TIPS are a relatively new security, so the US time series only goes back to 2003 but it’s a long enough period of time to give us a general idea of how inflation expectations have developed.
We observe that the yields for both 10-Year Treasury Bonds and 10-Year TIPS have been generally declining. The Breakeven Inflation Rate by comparison has been relatively stable. During the Financial Crisis and more recently during the COVID Collapse you see the Breakeven Rate drop precipitously reflecting expectations by the market that the general price level will fall steeply in the future. Over the approximate two-decades of the series however we see that the rate has averaged between 1.5% and 2% representing a stable outlook for inflation which is consistent with the FED’s 2% inflation target.
It is worth noting that the link between the Breakeven Rate and “true” inflation expectations is not set in stone. There is no economic law governing the relationship between the two securities that prescribes the forecasted rate of inflation. If we use the Crisis as a constructive example, we observe that around 2009 the Breakeven rate was approximately 0%. It is unlikely that anyone actually thought that in 10-years the rate of inflation would be 0% (unless the prevailing theory was that the economy would collapse entirely, which, to be fair, seemed plausible). Rather we should view the Breakeven Inflation Rate estimate as just that, an estimate that can provide us some useful information on the outlook for future inflation.
Thanks for taking the time to learn a little more about inflation!
-Aric Lux.
