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How To Estimate “Rational” Market Expectations Of Future Inflation

How To Estimate “Rational” Market Expectations Of Future Inflation

 I am not a fan of rational expectations, hence the quotation marks around “rational” in the subject head here.  Nevertheless I have become aware thanks to some posts at Econbrowser by the intrepid Menzie Chinn that the usual way this has been measured and reported by most people needs to be modified, with the understanding of this only developing quite recently.  This came from a paper in 2018 by some Fed Board of Governors economists: S. D’Amico, D.H. Kim, and M. Wei, (although Menzie refers to it as the “DKKW model”), “Tips from TIPS: The Informational Content of Treasury Inflation-Protected Inflation Securities,” Journal of Financial and Quantitative Analysis, 2018, 53(1), 395-436. 

For a given time-horizon, it has been conventional for those estimating such a “rational” market forecast of expected inflation to take the appropriate Treasury security nominal yield of that time horizon (say 5 years) and simply subtract from it the yield on the same time horizon TIPS, which covers security holders for inflation.  So it has long looked like this difference is a pretty good estimate of this market expectation of inflation, given that TIPS covers for it while the same time horizon Treasury security does not.