Tuesday, July 28, 2009

TIPs Spreads and CPI

Let's take a look at a chart I created showing the 5,10,20 yr TIPs spreads with the CPI. Of course this is just a tool to understand direction of inflation rather than the amount, as the CPI underestimates the real rate of inflation. Interestingly, it appears that the TIPs market may be embracing this notion, thereby pricing in a higher yield (suppressing spreads) than it would if the CPI was accurate; sending the false signal of a low expected inflation rate. It may also simply be the TIPs market successfully anticipating a drop in future CPI. Most of this is unimportant, rather the direction and pattern of these spreads is important to follow vis-a-vis the CPI.

Two things to take from this chart: notice during the great Deflation Scare how minimal the drop in the CPI price level was. Unless that starts falling again(and remember it already understates real inflation) we should accept the fact that the monetary system/economy is in a period of 'reflation'. The other is that TIP spreads have strongly rebounded and we're getting to a point in the CPI price level where the Y/Y changes in future CPI numbers will be based on better comparisons, indicating that, because these two measures should converge (and the y/y CPI has mainly stayed above the TIPs spread in the near past), we should expect the y/y CPI to rise in the coming months.