Assessing the term structure of expected inflation using treasury inflation—protected securities: near real-time measures for those who need quick estimates

Business Economics, Jan, 2003 by Albert E. DePrince, Jr.

Expected inflation (i.e., inflation forecasts) also has a term structure dimension. Expected inflation varies by the forecast horizon considered by the forecaster. In this regard, short- and long-term inflation forecasts are regularly obtained through at least two surveys. The Survey of Professional Forecasts (SPF) collects forecasts over one- and ten-year horizons on a quarterly basis. These forecasts are reported in Figure 1 and discussed in detail later in this paper. The Blue Chip Financial Survey also collects forecasts, over a five-quarter horizon, in each of its monthly surveys and collects inflation forecasts over a ten-year horizon twice a year.

If short-term inflation forecasts are less than long-term inflation forecasts, expected inflation has a positive term structure. It would have a negative term structure when short-term expected inflation is above long-term expected inflation. Based on the notion that the expected inflation has a term structure dimension, it is possible to account for the shape of the yield curve by different expected inflation rates over the different maturities along the yield curve.

Expected Inflation and the Composition of Interest Rates

In this section, the model of expected inflation is developed. In it, the spread between the conventional and inflation-protected securities of roughly the same maturity is treated as the market's measure of expected inflation for a forecast horizon equal to the maturity of the two securities. But as the discussion shows, the spread incorporates various premiums and is, at best, an approximation of expected inflation.

To begin, finance textbooks generally portray the yield on a default-free, highly liquid security, typically portrayed as a Treasury security, with a maturity of m years at any given period as the real risk-free rate:

* plus the maturity risk premium for an investment horizon of m periods

* plus the inflation premium for an investment horizon of m periods

* plus the inflation risk premium for a horizon of m periods. (2)

Separately, the real risk-free rate is an equilibrium rate, equating the overall supply and demand for funds. The maturity risk premium is assumed to have a positive term structure, rising with the asset's maturity, but the inflation and inflation risk premiums have no a priori term structure shapes.

However, this model may be incomplete. During the fiscal 1998-2001 span, a shortage of Treasury securities, stemming from smaller auctions and curtailed auction cycles, seemingly produced a price premium on Treasury securities. Effects were seen in widened spreads between Treasury securities and corporate bonds of comparable maturities. This led to widespread debate on the usefulness of Treasury securities as pricing benchmarks for other securities, and various benchmark alternatives to Treasuries were suggested (Jones, 2002; Wojnilower, 2002; Zamsky, 2002).

This also suggests that an explicit account of supply and demand conditions should be made in explaining the yield curve's shape. Interestingly, there is a theoretical foundation for this argument. Of the four major yield curve hypotheses, (3) two explicitly take into account supply and demand. The segmented market hypothesis explains the yield curve's shape in terms of relative supply and demand for securities at different maturities. If premiums exist, they would have to be constant across maturities in this regime, a highly restrictive assumption.