Tuesday, August 2, 2011

5 Year Inflation Expectations

One way to estimate expected inflation is to look at the pricing of various securities. The government sells several types of securities that mature over a number of different time frames. To estimate what investors expect inflation to be over a given period you can look at the interest rate they charge on constant maturity securities versus inflation adjusted securities.

By subtracting the interest rate on constant maturity securities from inflation indexed securities you determine the premium that investors require in exchange for uncertainty of not knowing what inflation will be in the future. If investors expect higher inflation then they will demand a higher interest rate so that their returns aren't wiped out by inflation.

So by looking at the spread between these securities you can get a picture of what investors expect inflation to average over the lifetime of the securities.

Here are the data for 5 year constant maturity and inflation-indexed securities:

These graphs show the difference between the two securities, or the expected average 5 year inflation:

The rate as of 7/29 is 2.07%, and the average rate over the last 6 months is 2.11%.