Last Updated on April 26, 2022 by Rational thinking
How do you calculate the future inflation rate? Is it possible? Yes, it’s possible to estimate the future inflation rate. In this article, we show you how you can interpret what the traders in the bond markets believe about future inflation.
You can estimate the future inflation rate by looking at the difference between the ten-year yield of Treasury bonds and the inflation-adjusted TIPs rate. For example, if the 10-year Treasury bond is at 2.5% and the TIPs are at 1.5%, the expected inflation rate is 1% (2.5 deducted 1.5).
Understanding inflation is crucial for investors. Because of this, it might be beneficial to keep an eye on what the bond traders are doing. When it comes to macro questions, we believe bond traders are much better than stock traders.
For those investors under 50 years of age, inflation has never been a real issue, at least for those of us residing in the Western world. But Brazil, Russia, Zimbabwe, and Venezuela all experienced uncontrolled inflation – hyperinflation – within the last 30 years. Hyperinflation has a devastating effect on society – it breaks down. Likewise, changes in the future expected inflation rate can affect your assets, capital, and savings substantially.
What is inflation?
Inflation is a loss of purchasing power, normally because of an increased supply of money. In the long run, there is a strong correlation between the price of goods and services and the amount of money in circulation.
For example, if a central bank “prints” 20% more money, you can expect this money to enter the economy at some point in time later and thus increase the price of goods and services. However, it doesn’t necessarily transmit into a 20% rise in the inflation rate if most of this money is lying idle somewhere. The velocity of money is important.
Prices go up and down, and we all have different preferences. When the price of a good increases, you might change your preferences or habits and buy substitutes. That’s why it’s difficult to even calculate past inflation, not to mention the future inflation rate!
How do you calculate the future inflation rate? (How to measure future inflation)
As an investor you are more worried about the future inflation rate, and not so much about the past. If you’re saving for your pension, you need to make sure you get a positive real return after inflation, thus you should keep an eye on the expected future inflation rate. How do you do that?
You need to keep an eye on the action in the bond markets. The traders and investors in the bond markets are more likely better at calculating the future inflation rate than the stock market investors. Why?
Because if you expect the annual inflation rate to be 3% in the future, you need to set the interest on the bond higher than 3% to get a positive real return.
Because of this, you can use a very simple estimation of what the bond market thinks about the future inflation rate over the next ten years. Luckily, we have the ingredients ready to make this calculation.
Put simply, you use the difference between the ten-year yield of Treasury bonds and the inflation-adjusted TIPs rate. If the 10-year Treasury bond is at 2.5% and the TIPs are at 1.5%, the expected inflation rate is 1% (2.5 deducted 1.5).
Here is a graph showing the differential over the last five years (taken from yCharts):
As of today, May 2021, the market expects 2.42% inflation over the next decade, which is slightly more than the average.
Another measure to predict future inflation is to use the Michigan survey and deduct the ten-year Treasury bond rate (graph taken from Aswath Damodoran):
Of course, the future is unknown, but the bond players back their estimations by putting their money where their mouth is: they have skin in the game.