The Predictive Power of Treasury Securities: Estimating Changes in Market Expectations of Future Inflation

Abstract

Many courses in financial economics cover the estimation of forward rates implied in Treasury spot rates. A less well-known extension of this discussion shows how yields on TIPS and similar-maturity conventional Treasury securities may be used to extract the market's inflation expectation. We illustrate the use of this methodology with data for the beginning of 2007 and 2008. One interesting opportunity to apply this method arose in January 2008 around the time of two substantial federal funds target rate cuts by the Federal Reserve. Near-term and longer-term inflation expectations appear to have responded differently to the first and second interest rate cuts, which were only ten days apart. After reporting our results, we discuss caveats that should be taken into account when applying this method.