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How to measure inflation expectations

Summary:
[embedded content] What level of inflation do people expect over the next several years? We could look at some surveys to try to answer this question, but nothing beats market measures where participants have some skin in the game. One such method of measuring inflation expectations is to compare how Treasury markets price two types of bonds: “normal” bonds—with a constant nominal interest rate—and “inflation-indexed” bonds—with a yield that includes realized inflation. One can tease out inflation expectations by subtracting the real bond yield from the nominal yield. This is the so-called break-even inflation that we show in the graph above for all available maturities. The graph shows that these expected inflation rates fan out at particular times, typically downward. And, every

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What level of inflation do people expect over the next several years? We could look at some surveys to try to answer this question, but nothing beats market measures where participants have some skin in the game. One such method of measuring inflation expectations is to compare how Treasury markets price two types of bonds: “normal” bonds—with a constant nominal interest rate—and “inflation-indexed” bonds—with a yield that includes realized inflation. One can tease out inflation expectations by subtracting the real bond yield from the nominal yield. This is the so-called break-even inflation that we show in the graph above for all available maturities.

The graph shows that these expected inflation rates fan out at particular times, typically downward. And, every time, the shorter maturities seem to have the strongest reactions. This is simple arithmetic. For example, a 10-year expectation also contains the 5-year expectation; and, as long as expectations average out in the long run, the shorter-term expectation will be more variable. An exception would occur if the market expects “normal” inflation in the next five years, but “abnormal” inflation during the five years thereafter. That’s very unlikely to happen, at least in terms of expectations.

How this graph was created: Search for “break-even inflation,” select the series, and click “Add to Graph.” From the “Edit Graph” panel, open the “Format” tab and move the series up or down to order them chronologically in the legend.

Suggested by Christian Zimmermann.

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FRED Blog
The Federal Reserve Bank of St. Louis is the center of the Eighth District of the Federal Reserve System. This District includes Arkansas, eastern Missouri, southern Illinois and Indiana, western Kentucky and Tennessee, and northern Mississippi.

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