By William Dupor, Assistant Vice President and Economist
The Federal Reserve has set an explicit inflation target of 2 percent per year. In light of this target, Fed officials closely monitor both actual inflation and expected future inflation. While actual inflation is straightforward to assess using data published by the federal government (such as the Consumer Price Index and the Personal Consumption Expenditures Price Index), measuring inflation expectations is more challenging.
One prominent measure is the so-called “break-even inflation rate,” which is the spread between a standard nominal bond and an inflation-protected or inflation-indexed bond. The break-even inflation rate is the rate for which a risk-neutral investor would be indifferent in terms of coupon payments and the payment at maturity between the nominal and indexed bond.
While many governments and a few private companies issue both types of these bonds, financial market participants almost always look at the spread between U.S. Treasury bonds of the two types (such as 10-year Treasury notes and 10-year Treasury inflation-protected securities, or TIPS) in computing break-even inflation. This is because both nominal and inflation-indexed U.S. bonds are seen as virtually risk-free and also highly liquid.
From the summer of 2014 to early 2015, the break-even inflation rate experienced a precipitous decline. The break-even rate on 10-year U.S. Treasuries fell from 2.29 percent on July 31 to 1.54 percent on Jan. 13.
This decline may have concerned Fed officials, since one interpretation of the rate move was that the Fed was more likely to miss its inflation target in the future. Missing the inflation target on the downside could put the economy close to or in a deflation. Some economists, both inside and outside the Fed, believe that deflation can contribute to a stall in real economic activity.
More recently, however, this measure of inflation expectations has stabilized. Since mid-January, the rate has stayed within a range of 1.5 percent to 1.9 percent. While movements in the break-even inflation rate are difficult to predict, its recent stabilization may give some observers at least partial relief from the fears of deflationary pressures on the U.S. economy.