Why the Consumer Price Index (CPI) shouldn't be the only inflation data investors should keep an eye on

Ahead of the highly anticipated Federal Open Market Committee meeting on September 17-18, the latest inflation data provided good news for markets and investors. The consumer price index for August came in at 2.5% year-on-year, down from July's level of 2.9%.

The recent downtrend has been welcomed by all, but to be successful, investors need to understand not only the backward-looking data such as the consumer price index and other metrics, but also the forward-looking expectations. This information is an essential input for institutional investors (portfolio managers, analysts, strategists) and even central bankers.

What are TIPS?

It can be difficult to figure out what markets expect when it comes to key economic statistics, but thanks to the U.S. Treasury Inflation-Protected Securities market, we can easily see what future inflation expectations will look like at any time.

The TIPS market was created to provide an investment that yields a real rate of return adjusted for future inflation. It consists of a variety of U.S. Treasury securities with different maturities, the value of which fluctuates as inflation rises and falls. In particular, the principal amount is linked to changes in the Consumer Price Index (CPI).

This market offers bond investors the opportunity to earn real income that offsets the negative effects of future inflation.

What impact do TIPS have on inflation expectations?

To calculate the market's expected inflation rate, we need to understand the composition of the yield on both TIPS and nominal or conventional (non-TIPS) Treasury bonds.

The yield on a nominal Treasury bond consists of a real yield plus an additional premium equal to the expected inflation over the life of the bond. A TIPS bond compensates for inflation, so it can be considered a real yield. To calculate the implied inflation rate, we subtract the yield on the TIPS bond from the yield on a nominal Treasury bond with a comparable maturity. What is left is the implied annualized inflation rate over the life of these bonds.

Let's look at this with an example. The yield on the 5-year US Treasury note was 3.458% on September 10, while the yield on the 5-year US TIPS was 1.541%. If we take 3.458% and subtract 1.541%, we get 1.917%. Therefore, we can assume that the market is pricing in an annualized inflation rate of 1.917% for the next five years.

We can repeat the calculation using bonds with different maturities to get a more comprehensive picture of the inflation outlook, but how good is the market at predicting future inflation based on TIPS?

TIPS inflation expectations compared to the Consumer Price Index (CPI)

From historical data, we can get an idea of ​​the changes in market inflation over time. The chart below shows the 5-year inflation forecast as of December 31, 2000, along with the backward-looking CPI annual percentage rate for the same period.

Admittedly, the data do not match perfectly, as the CPI is a backward-looking, one-year measure, while the TIPS inflation expectations are forward-looking and show the average inflation expectation for the next five years. With this in mind, it is clear from the chart that the TIPS market is reasonably successful in predicting inflation trends and is ahead of the actual CPI.

If we move the TIPS inflation expectations data forward three months, the correlation between the two is actually R² of 71%, not bad for such a volatile data set. The same calculation with different TIPS maturities shows different degrees of correlation, with inflation expectations with shorter maturities being much more volatile than inflation expectations with longer maturities.

What does the TIPS market say about the inflation outlook?

From this calculation, we also determine the inflation outlook for different time horizons. The table below lists these expectations for one, two, five and ten years. The data shows that markets expect inflation to fall in the short term and then rise over time.

This news should be reassuring for the Federal Reserve. It confirms that markets believe inflation is heading in the right direction (downward) and that short-term cuts are justified. However, it also shows that markets are still debating whether we are facing a “soft landing” or a “hard landing” scenario.

In a “soft landing” scenario, the Fed manages to bring inflation down to its 2% target without a significant decline in growth. In a “hard landing” scenario, growth will decline much more quickly, pushing inflation below the Fed's 2% target.

Conclusion: The time for cuts has come

As expected, the market is expecting inflation to fall from current levels over the next two years, which would be expected in both scenarios. The longer-term 5-year expectation is now below the Fed's long-term inflation target of 2% and at its lowest level in nearly four years. While this is not too much of a cause for concern at the moment – it is an average over a longer period of time and is not far below 2% – it is still worth watching for signs of further deterioration.

If the longer-term numbers fall well below 2% and short-term expectations continue to fall, that would suggest that a hard landing could occur in the near future. The good news is that the recent decline in inflation expectations is consistent with expected cuts in the federal funds rate. Once again, all eyes are on the Fed, as most expectations are for the start of a rate-cutting cycle at the September FOMC meeting next week.