One kind of commentary I keep running across, even from people 26 sigmas smarter than me, goes like this: “Inflation fears are overblown. According to the Treasury Inflation-Protected bonds (TIPs) market, inflation is deteriorating rapidly because …”
Let’s go over the reasons why this kind of analysis is false and misleading:
1) It’s not very true according to its own (flawed) benchmarks. 5-year Treasuries issued at a coupon rate of 3.375% are now trading at 3.39%, basically the same yield as the coupon. 5-year TIPs, issued at a coupon rate of 2% (implying 1.375% CPI), are now trading at 1.12% yield. That’s nearly HALF the original coupon, and it implies that TIPs are almost twice as valuable (yield somewhat over half as much on the bond) as they were at issue. Additionally, the difference between TIPs yield and Treasury yield, as you can see for yourself, is not 1.375%. It’s 2.27%. That’s a huge increase in CPI inflation expectations relative to identical bond issues from earlier.
2) CPI is an extremely political benchmark, because all mandated growth in entitlement spending is indexed to it. So the government has an obvious incentive to understate it, and perhaps more importantly, there is an elite consensus on the issue. Therefore, it’s highly likely that CPI will be held down by all kinds of statistical magic, or less conspiratorially, the divergence between CPI and headline inflation should widen over time. Therefore, the Fed faces heavy political pressure (and everyone agrees that the Fed reacts to political pressure, at least slightly) to keep CPI down.
3) If you think inflation will rise, you probably don’t trust the Fed very much, since low inflation is part of the Fed’s job description. Therefore, you probably won’t trust the Fed’s measurement of CPI very much. Therefore, the last place you’re going to go to bet on rising inflation is the TIPs market. People who don’t trust the Fed have lots of better ways to bet on inflation than TIPs.
It’s analogous to walking up to a Wal-Mart checkout, slipping the card through the reader, and then saying to the clerk, “I think your products have been deteriorating in quality, and I think they suck!” You’re an idiot if you’re wrong and a bigger idiot if you’re right.
4) Even significant inflation fears now will only be a warble in the 5-year TIPs market, let alone longer-term TIPs, just because the length of the time horizon overshadows most current events. As long as people are willing to trade a Treasury/ Fed market, and thus trust it even to a lessened extent, there will always be the presumption that a spike in headline inflation will be met with subsequent money withdrawal to bring inflation back in line.
5) Even if you think CPI will exactly track “real” inflation, and that political considerations have nothing to do with CPI calculations whatsoever, you’re still not capturing the full effect of inflation. So you’re still missing out on some of the payoff of rising inflation. The methodology of CPI was altered dramatically in 1993 to effectively lower the stated rate of inflation by multiple percentage points per year, because the previous rate of inflation allegedly did not account for substitution effects, and so on and so forth; but under pre-1993 methodology, current inflation would be running over 7 percent, which incidentally is much closer to MZM minus real GDP.
For these reasons, I wish people would stop referring to the TIPs market as a valid indicator of inflation expectations. It isn’t.