What Affects TIPS?

Man does not live by bread alone, which considering what the price of wheat has been doing (cash spring wheat at Duluth is up 236% from a year ago), is no doubt a good thing. And given the propensity of government statisticians to exclude food and energy prices from various inflation measures, I guess we all can ignore higher grocery bills in the months to come.

Russian civilians trapped in Leningrad during the horrific World War II siege resorted to making ersatz bread from materials such as sawdust. I look forward to The Core Inflation Cookbook, by Ben Bernanke as told to Rachael Ray.

Treasury Inflation-Protected Securities (TIPS) are based not on any bogus core inflation measures, but rather on the All-Urban Consumer Price Index, not seasonally adjusted (CPI-U). Both food and energy are included, as are difficult-to-understand measures, such as owners' equivalent rent and hedonically adjusted prices for various consumer goods.

TIPS' Forecasting Record

As I discussed in September 2007, TIPS are anything but a pure measure of inflation expectations. The yields on conventional Treasury notes have been forced unnaturally low by the flight-to-quality trade. Even so, the 10-year breakeven rate of inflation of 2.32% seems wildly disconnected from reality.

Even though the role of markets is to measure, not to forecast, we should go back and check how well TIPS' contemporaneous forecasts matched up to the realized rate of inflation ten years later. As TIPS began trading at the end of January 1997 and we have CPI-U data through December 2007, we have eleven months of comparison for TIPS' forecasting ability.

Assessing the TIPS Market's Forecasting Ability

Click here for larger image.

Source: Bloomberg

A casual glance at the chart above might indicate TIPS were well off the market. This does not stand up to analysis, however. The average root-mean-squared error of their forecast was 39 basis points. Contrast this to the semi-annual Wall Street Journal survey of economists for a six month-ahead period; this root-mean-squared error is 70 basis points. To emphasize, TIPS' forecast error for 10 years is 56% of the economists' forecast error for six months.

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Howard L. Simons is president of Simons Research, a strategist for Bianco Research, a trading consultant and the author of The Dynamic Option Selection System. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.

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