Inflation Expectations
This material was originally created for
Starting Point: Teaching Economics
and is replicated here as part of the SERC Pedagogic Service.
and is replicated here as part of the SERC Pedagogic Service.
Summary
This case quantifies inflation expectations, as reflected in bond yields, over time. This activity can be used as either (a) an instructor-led example in which the instructor shows –either on paper or a screen– the data and students analyze them, or (b) as a student exploration in which students find the specified data. Instructors with less time could use option (a) and instructors interested in their students learning about the FRED database could use option (b).
This activity plots the yield of a non-inflation-adjusted Treasury bond (e.g. the 30-Year Treasury Constant Maturity Rate), the yield of an inflation-adjusted Treasury bond (e.g. the 30-Year Treasury Inflation-Indexed Bond), and computes the difference between the two of them. This difference is an approximation of inflation expectations developed by financial markets and it displays both a secular trend and cyclical behavior.
This activity is suitable for addressing each of the following issues:1. How do inflation expectations change over time?2. How did inflation expectations adjust after the 2008-2009 financial crisis?3. What is the relationship between monetary policy and inflation expectations?
This activity plots the yield of a non-inflation-adjusted Treasury bond (e.g. the 30-Year Treasury Constant Maturity Rate), the yield of an inflation-adjusted Treasury bond (e.g. the 30-Year Treasury Inflation-Indexed Bond), and computes the difference between the two of them. This difference is an approximation of inflation expectations developed by financial markets and it displays both a secular trend and cyclical behavior.
This activity is suitable for addressing each of the following issues:1. How do inflation expectations change over time?2. How did inflation expectations adjust after the 2008-2009 financial crisis?3. What is the relationship between monetary policy and inflation expectations?
Learning Goals
After the completion of this module students will be able to:
1. Use FRED graphs to perform data manipulations.
2. Use FRED graphs to perform a visual data comparison
3. Assess how inflation expectations change in value during expansions and contractions.
4. Understand the concept of volatility in inflation expectations.
1. Use FRED graphs to perform data manipulations.
2. Use FRED graphs to perform a visual data comparison
3. Assess how inflation expectations change in value during expansions and contractions.
4. Understand the concept of volatility in inflation expectations.
Context for Use
Ideally, this module should be directed to a financial economics or intermediate macroeconomics class. It can be used as either (a) an instructor-led example in a large lecture or (b) student groups can be assigned to replicate it outside of class as a basis for a short assignment. Between the presentation of the data and the ensuing discussion, instructors should allocate 20-30 minutes of classroom time. The discussion could focus on how to estimate inflation expectations and on the role of extrapolative expectations, or inflation persistence, in this regard.
Prerequisite skills: Graph literacy
Prerequisite concepts: Bond yields; Inflation-indexed bonds; Inflation expectations
Description and Teaching Materials
The following is a description of this activity being used as an instructor-led example. For a basic step-by-step description of this activity –also suitable for a student-led exploration of the topic– please see the Handout Activity Handout for Inflation Expectations (Microsoft Word 26kB Jun27 14).
The instructor will first present a graph of the 30-Year Treasury's Inflation-Indexed Bonds (WTP30A28) (Category: Money, Banking & Finance > Interest Rates > Treasury Inflation-Indexed Securities)
The instructor should point out that for the available data range the trend value of the Treasury bond yield has been declining. Narrowing the range of the data set to 2000-present will make that pattern more obvious. Special attention should be paid to the fact that the bond yield was negative between mid-2012 and mid-2013. This fact will become relevant when introducing an additional data series.
The instructor can ask students to review the relationship between bond yield and bond price, discussing how it is possible that a bond offers a negative yield. Questions of volatility can also be brought up by pointing out sudden and large changes in the value of the series.
(Step 2)
The instructor will then "Add a Data Series > Add New Series", graphing the 30-Year Treasury's Constant Maturity Bond Rate (DGS30) (Category: Money, Banking & Finance > Interest Rates > Treasury Constant Maturity)
The instructor should point out that although there is frequent co-movement between the series the yield of the inflation-indexed Treasury securities "never" exceeds the yield of the non-inflation-indexed Treasury securities. The instructor can ask students to put forward an argument for why that is the case. Thus having introduced the concept of inflationary expectations, or –alternatively– that of an "inflation premium", discussion should turn to late 2008 (the most dramatic stage of the financial crisis) when the yield on non-inflation-indexed Treasuries and the yield on inflation-indexed Treasuries were identical.
(Step 3)
The instructor will then "Edit Data Series 2" (30-Year Treasury's Constant Maturity Bond Rate (DGS30)) by deleting it [click on trash can icon to the right of the series' name].
Next, the instructor will "Add a Data Series > Modify Existing Series > Data Series 1", graphing 30-Year Treasury's Constant Maturity Bond Rate (DGS30) (Category: Money, Banking & Finance > Interest Rates > Treasury Constant Maturity)
These steps are needed in order to have both series as part of the same database object and allow for their manipulation. This manipulation is accomplished by selecting "Create Your Own Data Transformation > Formula > b – a > Apply"
The graph now plots the difference between non-inflation-indexed and inflation-indexed Treasuries, a computation of inflation expectations.
The following is a list of questions that could be asked:
- What average value did inflation expectations have before the 2008-2009 recession? What are the implications of such stable inflation expectations for bond prices?
- What average value did inflation expectations have after the 2008-2009 recession? Consider both the magnitude and the volatility of those figures. What are the implications of such volatile inflation expectations for bond prices?
Further sophistication:
- Plot the difference between the 10-Year Treasury's Constant Maturity Bond Rate (DGS10) and the 10-Year Treasury's Inflation-Indexed Bonds (WTP10J14). Compare with the previous graph. Discuss how and why 10-Year and 30-Year inflation expectations are different.
Within a lecture discussing real and nominal interest rates, an instructor will use this module to help students understand the concept of inflation expectations and to guide a discussion of their quantification.
(Step 1)The instructor will first present a graph of the 30-Year Treasury's Inflation-Indexed Bonds (WTP30A28) (Category: Money, Banking & Finance > Interest Rates > Treasury Inflation-Indexed Securities)
The instructor should point out that for the available data range the trend value of the Treasury bond yield has been declining. Narrowing the range of the data set to 2000-present will make that pattern more obvious. Special attention should be paid to the fact that the bond yield was negative between mid-2012 and mid-2013. This fact will become relevant when introducing an additional data series.
The instructor can ask students to review the relationship between bond yield and bond price, discussing how it is possible that a bond offers a negative yield. Questions of volatility can also be brought up by pointing out sudden and large changes in the value of the series.
(Step 2)
The instructor will then "Add a Data Series > Add New Series", graphing the 30-Year Treasury's Constant Maturity Bond Rate (DGS30) (Category: Money, Banking & Finance > Interest Rates > Treasury Constant Maturity)
The instructor should point out that although there is frequent co-movement between the series the yield of the inflation-indexed Treasury securities "never" exceeds the yield of the non-inflation-indexed Treasury securities. The instructor can ask students to put forward an argument for why that is the case. Thus having introduced the concept of inflationary expectations, or –alternatively– that of an "inflation premium", discussion should turn to late 2008 (the most dramatic stage of the financial crisis) when the yield on non-inflation-indexed Treasuries and the yield on inflation-indexed Treasuries were identical.
(Step 3)
The instructor will then "Edit Data Series 2" (30-Year Treasury's Constant Maturity Bond Rate (DGS30)) by deleting it [click on trash can icon to the right of the series' name].
Next, the instructor will "Add a Data Series > Modify Existing Series > Data Series 1", graphing 30-Year Treasury's Constant Maturity Bond Rate (DGS30) (Category: Money, Banking & Finance > Interest Rates > Treasury Constant Maturity)
These steps are needed in order to have both series as part of the same database object and allow for their manipulation. This manipulation is accomplished by selecting "Create Your Own Data Transformation > Formula > b – a > Apply"
The graph now plots the difference between non-inflation-indexed and inflation-indexed Treasuries, a computation of inflation expectations.
The following is a list of questions that could be asked:
- What average value did inflation expectations have before the 2008-2009 recession? What are the implications of such stable inflation expectations for bond prices?
- What average value did inflation expectations have after the 2008-2009 recession? Consider both the magnitude and the volatility of those figures. What are the implications of such volatile inflation expectations for bond prices?
Further sophistication:
- Plot the difference between the 10-Year Treasury's Constant Maturity Bond Rate (DGS10) and the 10-Year Treasury's Inflation-Indexed Bonds (WTP10J14). Compare with the previous graph. Discuss how and why 10-Year and 30-Year inflation expectations are different.
Teaching Notes and Tips
There is an ever-growing trove of Economic Letters by the Federal Reserve Bank of San Francisco discussing the accuracy of inflation forecasting efforts, the quantification of inflation expectations across countries, and the impact of inflation expectations on long-term bond yields (see full references under Resources). These are great resources to carry the discussion further.
The popular press picked up on the fact that inflation-indexed Treasuries offered negative yields towards the end of 2008. This, and other pieces like it, can be used to provide more poignant context. An example is "Yields on TIPs Go Negative" (see full reference under Resources).
The popular press picked up on the fact that inflation-indexed Treasuries offered negative yields towards the end of 2008. This, and other pieces like it, can be used to provide more poignant context. An example is "Yields on TIPs Go Negative" (see full reference under Resources).
Assessment
The recommended method for assessment for an intermediate macroeconomics or financial economics class would be to have students write up a short memo where they discuss the historical evolution of inflation expectations computed as the difference between non-inflation-indexed and inflation-indexed Treasury bonds. This should be a take-home assignment.
References and Resources
"Financial Market Outlook for Inflation" by Michael D. Bauer and Jens H. E. Christensen
Federal Reserve Bank of San Francisco Economic Letter 2014-14, May 12, 2014
http://www.frbsf.org/economic-research/publications/economic-letter/2014/may/financial-market-outlook-inflation-derivatives/
"Consumer Inflation Views in Three Countries" by Bharat Trehan and Maura Lynch
Federal Reserve Bank of San Francisco Economic Letter 2013-35, November 5, 2013
http://www.frbsf.org/economic-research/publications/economic-letter/2013/november/consumer-inflation-expectations-us-uk-japan-oil-prices/
"What Caused the Decline in Long-term Yields?" by Michael D. Bauer and Glenn D. Rudebusch
Federal Reserve Bank of San Francisco Economic Letter 2013-19, July 8, 2013
http://www.frbsf.org/economic-research/publications/economic-letter/2013/july/cause-decline-long-term-us-government-bond-yields/
"Yields on TIPS Go Negative --- Big Demand for Bonds Suggests Fed Is Winning
Deflation Battle; It 'Is Striking'" by Mark Gongloff and Deborah Lynn Blumberg
Wall Street Journal (WSJ.com) October 26, 2010
http://online.wsj.com/news/articles/SB10001424052702304388304575574060921403190
Federal Reserve Bank of San Francisco Economic Letter 2014-14, May 12, 2014
http://www.frbsf.org/economic-research/publications/economic-letter/2014/may/financial-market-outlook-inflation-derivatives/
"Consumer Inflation Views in Three Countries" by Bharat Trehan and Maura Lynch
Federal Reserve Bank of San Francisco Economic Letter 2013-35, November 5, 2013
http://www.frbsf.org/economic-research/publications/economic-letter/2013/november/consumer-inflation-expectations-us-uk-japan-oil-prices/
"What Caused the Decline in Long-term Yields?" by Michael D. Bauer and Glenn D. Rudebusch
Federal Reserve Bank of San Francisco Economic Letter 2013-19, July 8, 2013
http://www.frbsf.org/economic-research/publications/economic-letter/2013/july/cause-decline-long-term-us-government-bond-yields/
"Yields on TIPS Go Negative --- Big Demand for Bonds Suggests Fed Is Winning
Deflation Battle; It 'Is Striking'" by Mark Gongloff and Deborah Lynn Blumberg
Wall Street Journal (WSJ.com) October 26, 2010
http://online.wsj.com/news/articles/SB10001424052702304388304575574060921403190