Influential Expectations

When referencing prices, nominal simply means the actual quoted price of a good at a given time.  Real is a concept used to remove the inflation effect on prices and compare the true value of a good in different time periods.  For example, the US average price of gasoline recently hit $5/gallon.  To truly understand how expensive today’s prices are, we would have to account for inflation and adjust past gas prices to be quoted in 2022 dollars.  The inflation adjustment makes it a “real” value comparison.

Real and Nominal also have a unique meaning when it comes to interest rates, and again inflation is a key component.  Nominal interest rates are the value you see quoted for a loan, a certificate of deposit, or yield on a bond.  The total nominal interest rate is made up of several components: the real interest rate, a risk premium, and expected inflation.  The real interest rate is the underlying cost of using someone else’s capital for a period of time.  The risk premium accounts for the uncertainty of the loan due to the credit worthiness of the borrower and/or how the loan is to be used.  Finally, expected inflation is added to account for the change in purchasing power between original loan proceeds and the loan repayment at a later date.  If, for example, a lender was expecting 5% inflation over the next year, the real interest rate was around 1.5%, and the risk premium was another 1% (the lender thinks the borrower is a trustworthy fellow), he would quote a nominal interest rate of 7.5%. 

Expected inflation is an important part of the greater economic picture today.  Peoples’ feelings and expectations about future inflation influence how they buy, sell, borrow, lend, and negotiate prices in the market place.  In no small part, expected inflation can create a self-fulfilling prophesy.  All of this brings us to an interesting bit of economic data that gives us a hint at today’s market expectations for inflation.  Nominal interest rate quotes are readily available, but the components as described above are not transpartent in those quotes; at best, they can be estimated.  One such estimate is known as the TIPS spread or the 5-Year Breakeven Inflation Rate.  TIPS refers to Treasury Inflation-Protected Securites which are adjusted to offset inflation.  The nominal yield for regular Treasury notes includes real interest rates, virtually no risk, and market expectations for inflation.  The yield on TIPS has the same components but excludes expected inflation, therefore the market’s expectation of inflation is revealed in the spread, or yield difference, between the two types of notes.  Figure 1 shows the TIPS spread on five-year Treasury notes over the past twenty years.  The TIPS spread quickly rose from near zero at the onset of the pandemic to a high of 3.5% in mid to late March.  The spread has since fallen back to around 2.75% as of last week.  The decline over the last three months coincides with the Fed’s more aggressive action to fight inflation.  It’s too early to tell if the Fed’s higher interest rates are slowing down inflation, but this early indication in the TIPS spread suggests market expectations are improving with regard to inflation.  If your glass if half full, it’s an encouraging step it the right direction.  If your glass is half empty, a decline in inflation expections also reflects a growing concern about a future recession.  In reality, both interpretations are relevant regardless of how much water is in your glass.    

Figure 1. Daily Yield Difference between Regular and Inflation-Protected 5-Year Treasury Notes

Data Source: St. Louis Federal Reserve Bank

Klose, Steven, and John D. Anderson. “Influential Expectations.” Southern Ag Today 2(28.3). July 6, 2022. Permalink