Tuesday, October 2, 2007

Inflation Risk Premium Conundrum?

How has the Bush Administration been doing with the inflation risk premium?

It turns out that it is not as bad as one might expect, another extension of the Greenspan-dubbed 'conundrum'. Either that or inflation hedging tools have gotten to the point where people can lay off the risk and it's not in the numbers completely (not so likely).

One can compare the real rates observed from the Treasury's Inflation Protected Securities (TIPs) to the real rates implied by a difference between nominal interest rates and some measure of inflation, typically the CPI.

The difference between the rates might be explained as a combination of the all-important inflation risk premium and the difference between true inflation expectations and the CPI inflation measure used in the calculation. To short-hand it, I'll just call this whole quantity the "inflations expectations risk premium" (IERP), which is a nonsense term that somehow seems to still convey the quantity's essence.

The first thing to note is that real rates have been trending up. Until the last quarter of 2005, say, they were below 2%, in the range of 0.5%-2.0%; and they are now back above 2%, in the range of 2-2.5%. Trend lines for both the 5-yr and 10-yr are positive, so it's not just a flattening of the yield curve over the period. (Gone are the days when one could get a 4% real yield on offer with TIPs. The rise in real-rates is a reminder that investors can lose money in TIPs, over certain intervals.)

The second thing to note is that the trend IERP is flat. Under adverse circumstances, one might reasonably expect both a rising risk inflation-risk premium and expectations of future inflation rate ahead of the current measured inflation rate. So, a flat IERP is good news, but also part of the "conundrum".

The IERP bounces around in its range, mostly with an average of about 0.5% and a standard deviation of circa 0.65%. (The fact that its volatility doesn't appear to be diminishing suggests that real rates may continue to be less volatile than nominal rates).

The latest IERP reading is below average, negative (just barely), and low (more than one standard deviation from its period average - a range of +/- 1 deviation is highlighted on the chart). Based on that, one might easily conclude that the bond markets are not expecting any accelerating inflation and, in fact, may be expecting either higher nominal rates or lower realized inflation (of about 0.5%, the amount that the current IERP reading is below its period average).

The impact of the latest Fed easing has been very small.

inflation and inflation 6-month moving average is in red; stair-step is Fed Funds rate; rate line collection in the middle are TIPs (with black trend line), the rate line collection beneath is the "IERP", with one standard deviation corridor in whitewash centered around the flat, IERP trendline shown in black.

src: US Treasury, BLS

No comments: