What is the Market-Implied Inflation Rate?

The Importance of Tracking Inflation Expectations

• Tracking the trend of inflation is important since it impacts the purchasing power of money. That is, inflation erodes purchasing power which can impact our lifestyle because it can limit what we can buy given a fixed paycheck or retirement nest egg.

• Inflation expectations also impacts interest rates, investment decisions, corporate spending, hiring plans and annual wage adjustments.

• Inflation also can benefit borrowers since it allows debts such as mortgage loans to be repaid with less valuable dollars. On the other hand, lower than expected inflation means “real” or inflation-adjusted interest rates are higher than expected and therefore benefits savers.

• Finally, inflation is a key component used in setting monetary policy by the Federal Reserve. The Federal Reserve has a stated goal of seeking a long-term inflation rate of 2.0% while seeking to achieve maximum employment. As a result, the Fed’s interest rate policy is geared toward achieving these objectives.

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Historical Inflation Rates (1990-2024)

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During the past 35 years, US Inflation has averaged 2.7% ranging from a low of -0.1% in 2009 to a high of +8.0% in 2022.

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How is the Market Implied Inflation Rate Calculated?

The Implied Inflation Rate is the difference in yields between Treasuries and TIPs of the same Maturity.

Note the Market Implied Inflation Rate is also known as the Breakeven Inflation Rate

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As shown above the Breakeven Inflation Rate in 5-Years is higher than 10-Years (2.56% vs. 2.41%), and the market implied inflation rate curve is inverted. This means that the market is expecting the inflation rate to decline over the longer-term. Additionally, all three key TIPs maturities shown above have Breakeven Inflation rates below the long-term historical inflation rate of 2.7% (shown on prior chart).

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How to interpret the Breakeven Inflation Rate

If investors believe that actual inflation will be above 2.41% over the next 10-years, then they should buy TIPs since they have inflation upside and will benefit from higher than expected inflation. On the other hand, if inflation is lower than the Breakeven level investors are better off owning Treasuries. Note the breakeven inflation rate, like the Treasury and TIPs rates change with the markets all day, every day.

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“The arithmetic makes it plain that inflation is far more devastating tax than anything that has been enacted by our legislatures.” – Warren Buffet

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