Discontinued Expectations II

One month ago, the Cleveland Fed stopped publishing their inflation expectations derived from the TIPS spread.

Two days ago…  Wait, let me start from the beginning.  First, some definitions.

A 5-year bond sold by the Treasury today is said to be on the run.

A 10-year bond sold by the Treasury five years ago is said to be off the run.

For normal Treasuries, these two instruments are essentially indistinguishable, because they represent the same obligation of the U.S. government; that is, they will pay you interest and principal for the next five years.

But a TIPS bond is different.  It has an embedded “multiplier” that starts at 1 when the bond is issued.  The multiplier rises and falls with inflation — specifically, the CPI — and is applied to all interest and principal payments.  (This is how you get the “inflation protected” feature.)  But the multiplier never goes below 1.

So a newly issued (“on the run”) 5-year TIPS has an embedded multiplier of 1, while an “off the run” TIPS issued five years ago has a multiplier of 1.2 or so.

If we experience inflation in the next few years, or inflation followed by mild deflation, then this distinction makes no difference; the on-the-run and off-the-run TIPS will yield the same payments.  But if we are going to experience deflation first, then the on-the-run TIPS will yield higher payments and therefore be more desirable.

Now, if you are looking at the yields on TIPS to get an idea of what kind of inflation the market expects, which would you want to use?  The one that actually tracks the CPI, or the one that has an artificial floor in it?

Greg Mankiw: Real Interest Rates Plunge!

According to U.S. Treasury data, the five-year real interest rate from the TIPS market on 11/28/08 was 4.17 percent. Yesterday, it was 2.03 percent.

That is a huge change over only a few days. What happened? It appears to be, in large measure, a figment of data construction.

Here is how the data are made:

Real yields on Treasury TIPS (Treasury Inflation Protected Securities) at “constant maturity” are interpolated by the U.S. Treasury from Treasury’s daily real yield curve. These real market yields are calculated from composites of secondary market quotations obtained by the Federal Reserve Bank of New York.

And this is what you find in the footnotes:

Starting 12/01/2008, the TIPS yield curve will use on-the-run TIPS as knot points rather than all securities under 20 years.

As I have said before, this Federal Reserve is real big on “inflation expectations”.  They believe that inflation and deflation have less to do with actual, you know, money and more to do with self-reinforcing psychological feedback loops.  The last thing they want is for some pimply-faced researchers at the St. Louis Fed to give people the idea that deflation may be coming.

If you do not like the data, stop publishing it.  Or just change the way it is calculated.  Problem solved!  This approach has a long and glorious tradition in many third-world nations; it is nice to see the U.S. finally catching up.

Anyway, as of December 1, the Treasury and St. Louis Fed are on board.