Market-Based Inflation Expectations and Inflation Realities: A Comparison of the Treasury Breakeven Inflation (TBI) Rate Curve and the Consumer Price Index before, during, and after the Great Recession

This paper examines the extent to which market-based inflation expectations overshot or undershot actual inflation in the years before, during, and after the financial crisis of 2008-09. Specifically, it compares the U.S. Treasury Breakeven Inflation (TBI) Rate Curve, a unique measure of market-based inflation expectations that computes monthly breakeven inflation rates for short and long-term maturity horizons in 6-month increments, to the U.S. Bureau of Labor Statistics’ Consumer Price Index for All Urban Consumers, U.S. City Average, All Items, in the 175 months from July 2003 to January 2018. The analysis has three main findings. First, it finds that average deviations between TBI breakeven rates and respective annual CPI inflation rates per maturity horizon never exceeded 80 basis points, and for horizons of 2 years or more, never exceeded 55 basis points. Moreover, median deviations per maturity horizon never exceeded 70 basis points (except at the 1-year maturity horizon). In short, market-based inflation expectations, as measured by the U.S. Treasury Department TBI Curve, reasonably approximated realized inflation in the years before and after the financial crisis. Second, estimates tend to overshoot for short-term maturity horizons and undershoot for long-term maturity horizons, which likely reflects the effects of a liquidity premium on Treasury Inflation-Protected Securities (TIPS) in the early years of inflation-indexed debt issuance. Third, the dispersion of deviations, as measured by standard deviation and range, decreases as the maturity horizon increases. Thus, inflation expectations approximated inflation reality during the years before, during and after the crisis, with greater precision for long-term rates than short-term rates. At the height of the financial crisis, however, volatility, as measured by tracking risk (i.e. the standard deviation of the differences between breakeven rates and realized inflation rates), was high for the 6-month and 1-year maturity horizons.