New York Fed: "Creating a History of U.S. Inflation Expectations"

From the Federal Reserve Bank of New York's Liberty Street Economics blog:

Central bankers closely monitor inflation expectations because they’re an important determinant of actual inflation. Treasury inflation-protected securities (TIPS) are commonly used to measure bond market inflation expectations. Unfortunately, they were only introduced in 1997, so historical data are limited. We propose a solution to this problem by using the relationship between TIPS yields and other data with a longer history to construct synthetic TIPS rates going back to 1971.

Using TIPS to Measure Inflation Expectations
The United States, like many other countries, learned the importance of inflation expectations during the 1970s, when employees demanded wage increases to protect themselves against higher inflation, which resulted in businesses passing along increased labor costs in the form of higher prices. Unfortunately, inflation expectations are difficult to measure. One way is to ask people what they expect through surveys. Another is to use inflation-linked bonds.

        TIPS are publicly traded government debt securities that compensate investors for the change in consumer prices. So while nominal Treasury holders demand a higher yield to offset expected future inflation, owners of TIPS are willing to accept an initial lower yield. The difference between the nominal yield on ordinary Treasuries and the real yield on TIPS (called the break-even rate) reflects expected inflation.

However, nominal bondholders also recognize that actual inflation may deviate from the expected rate and, if they’re risk averse, will also want to be compensated for this uncertainty. In addition, investors care about the liquidity of a security because they don’t like to sell at a discount if they need to unload their holdings. While TIPS offer insurance against inflation, they’re also less liquid than nominal Treasuries; as a result, the break-even rate reflects both inflation risk and liquidity premiums in addition to expected inflation.

Nevertheless, the break-even rate is the most commonly used measure of inflation expectations. One reason for this is that bondholders have an incentive to forecast accurately. Another is that break-evens are available in real time. Unfortunately, TIPS aren’t directly useful in helping to understand periods of high inflation, like the 1970s, because they didn’t exist until 1997, and inflation has subsequently been low and relatively stable.

How to Forecast the Past
Fortunately, if we can estimate a relationship between real yields and longer time series and are willing to assume that the relationship is stable over time, then we can use a “backcasting” procedure to construct a TIPS real yields series for earlier time periods. Then we can use historical nominal bond yields to calculate break-even rates. We believe it makes more sense to backcast real yields rather than attempt to estimate historical break-evens directly, because while inflation expectations are unbounded, historical real interest rates are likely closer to levels experienced since 1997.

We select 108 monthly time series dating back to 1971 that are plausibly related to real yields. Nominal yields are at the top of the list because they’re the sum of real yields and inflation expectations. Changes in real yields should thus result in changes in nominal yields....MUCH MORE