Questions about TIPS
The 10 treasury bond is yielding around 1.7% (none of what follows relies on the exact values of the numbers).
The 10 year TIPS yield is around -.7%. So a common calculation of inflation expectations, so called break-even inflation is at 2.4%.
From this information, I arrive at two important (at least to me) questions:
(1) Is this a reasonable measure of inflation expectations and (2) If so, what does it mean about the economy?
I question (1) because of concerns about the lack of liquidity in the TIPS market, the old issues of market segmentation, and just generally because equilibrium conditions in financial markets that aren’t enforced by pure arbitrage don’t actually seem to hold in the data.
I did a bit of research and found a couple Fed branch bank papers on the topic (see here and here). Both papers conclude (if I am reading them correctly) that the break-even inflation calculation of inflation expectations probably understates expected inflation!
So that leads to question 2. If Inflation expectations are above 2.4%, but the 10 year treasury is yielding 1.7%, why are people holding 10 year treasuries? Because the equilibrium real interest rate on safe securities is negative, like around -1.0%? 4 years after the crisis, risk aversion is so high that people are willing to accept a negative return for in exchange for safety? So either the supply of safe assets is very small, or the demand for safe assets is overwhelmingly high?
If inflation expectations at the 10 year window are rising, but returns on 10 year treasuries are simultaneously falling, then the equilibrium real rate of interest on safe assets is getting lower and lower (in our case more and more negative).
Does this mean that 4 years after the crisis, people’s willingness to undertake risky investments is actually falling? If so, isn’t that a very bad sign for the direction of future economic activity? The Baa seasoned bond yield is 4.9%. If inflation expectations are 3%, then the real return to capital is 1.9%?
Or does it mean somehow that the supply of safe assets is shrinking faster than the demand for safe assets is falling? Can we just blame Europe?
Or are we just making a big mistake in calculating inflation expectations?