Forecasting Inflation: What Affects TIPS?

Forecast Basis

Given all of the distortions involved in the TIPS market and the impossible task of forecasting almost anything 10 years in advance, we have to ask what TIPS traders might be looking at. Here the answer becomes shrouded in mystery at first, and then produces a surprising answer.

Let's round up some of the usual suspects normally but erroneously associated with inflation, such as gasoline, gold and the shape of the money-market yield curve. The price of gasoline, as all of us have noticed, has increased fairly substantially since the spring of 1999. And yet, if we look at the chart below, we are hard-pressed to find any sort of relationship between wholesale gasoline prices and TIPS breakevens since their May 2004 peak (noted on all subsequent charts with a green vertical line).

TIPS' Breakeven Ignored Gasoline

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Source: Bloomberg

What about gold? As first noted here in May 2003, gold should rise when expected inflation exceeds the short-term interest-rate cost of holding gold. And yet, gold has more than doubled since May 2004, while TIPS breakevens have remained confined.

TIPS' Breakeven Ignored Gold's Rise

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Source: Bloomberg

Well, what about the other part of that gold equation, monetary largesse? If we measure the shape of the money-market curve by the forward-rate ratio between three and six months, the rate at which we can lock in borrowing for three months starting three months from now, divided by the six-month rate itself, we see how the money-market yield curve has flattened substantially since May 2004.

TIPS' Breakeven Peaked as LIBOR Curve Flattened

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Source: Bloomberg

This flattening -- any number less than 1.00 indicates the three-month rate exceeds the six-month rate -- has proceeded through the 17 consecutive rate hikes between June 2004 and June 2006, the subsequent period of the Federal Reserve being on hold and the 225 basis points of rate cuts since September 2007. This flattening seems to exert downward pressure on inflation expectations.