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Measuring expected inflation with data from the Cleveland Fed

The FRED Blog has discussed inflation expectations by showing different types of data in FRED. For example, Thomson Reuters and the University of Michigan conduct the monthly Surveys of Consumers, asking people to select the inflation rate they expect to see a year from today. Also, the Federal Reserve Bank of St. Louis calculates the daily breakeven inflation rate, which is computed as the difference in returns of types of constant-maturity Treasury bills: one being the traditional bill and the other being the inflation-indexed bill.

The FRED graph above shows another measure of inflation expectations that combines data from constant-maturity Treasury bills, survey forecasts of inflation, and inflation swap rates. These expected annual inflation rates for the next 30 years are produced by the Federal Reserve Bank of Cleveland.

At the time of this writing, the expected inflation rate for 2022 is 2.46% and the expected rates for 2023 and 2024 are 1.96% and 1.80%, respectively. Note that when you hover over the graph the date next to each expected inflation rate is the month and year when the expectation is calculated. Between the months of January and November 2021, those expectations changed in value rather noticeably. However, as the time horizon extends farther and farther into the future, the expected inflation rates become markedly less volatile and very similar in value. That is, the green 3-year line shows less variation than the red 2-year line, which shows less variation than the blue 1-year line. This suggests that financial market indicators, survey responses, or both point to medium- and long-term price stability.

How this graph was created: Search for and select “1-Year Expected Inflation.” From the “Edit Graph” panel, use the “Add Line” tab to search for and select “2-Year Expected Inflation.” Repeat the last step to add “3-Year Expected Inflation” to the graph.

Suggested by Diego Mendez-Carbajo.

Measuring expected inflation with breakevens

A U.S. Treasury security typically promises to repay an investor a flow of coupon payments and then principal repayment once the security matures. These payments are made in U.S. dollars. A security that promises to deliver future dollars is called a nominal security. Most U.S. Treasury securities are nominal securities.

Nominal securities do not offer investors protection against unexpected inflation. The purchasing power of future dollars declines as the cost of living increases. In short, the same dollars buy fewer goods. To help protect investors against inflation risk, the U.S. Treasury also issues “real’’ securities—that is, securities that are indexed to the rate of inflation (or cost of living) as measured by changes in the consumer price index (CPI). These Treasury inflation-protected securities (TIPS) promise to deliver more dollars when the CPI is higher and fewer dollars when the CPI is lower.

These two types of securities can be used to infer bond market expectations of future inflation. The basic idea is simple: Consider a security that matures in, say, 5 years. FRED shows us that the annual yield on a 5-year TIPS is presently –1.65%. We can interpret this number as the real (inflation-adjusted) yield on a 5-year TIPS. FRED also shows us that the annual yield on a 5-year nominal Treasury security is 1.33%. If investors are indifferent between holding the two securities in their wealth portfolios, then they must be yielding something close to the same inflation-adjusted rate of return. This would be true if investors were expecting an average inflation rate over the next 5 years equal to 1.35% – (–1.65%) = 3%. To put things another way, for an investor to break even on a bet between a nominal and inflation-protected security, the expected rate of inflation would have to be 3%. For this reason, this market-based measure of inflation is called the breakeven inflation rate.

The FRED graph above shows that the 5-year breakeven inflation rate averaged close to 2% in the years leading up to the COVID-19 crisis. After an initial decline in early 2020, expected inflation over the next 5 years has risen steadily to about 3%. The reason behind this increase is hotly debated. The breakevens do not tell us the cause of inflation. They provide us only with a measure of inflation expectations.

How this graph was made: Search for and select “Market Yield on U.S. Treasury Securities at 5-Year Constant Maturity, Inflation-Indexed.” From the “Edit Graph” panel, use the “Add Line” tab to search for and add the remaining two series.

Suggested by David Andolfatto and Joel Steinberg.

Bank branch density and economic development

An important component in the development of an economy is for the population to be “banked”—that is, to have a bank account to save money and participate in the payment system. One indicator of the amount of banked people in a location (e.g., a state or country) used to be the number of bank branches in that location. The FRED graph above shows this statistic for a non-random set of countries: Mongolia, the United States, and Nigeria.

If this statistic is in some way representative of economic development, why is the number of bank branches in Mongolia so much higher than in the United States? And why are the numbers for the United States and Nigeria declining despite continuous economic growth?

The issue is that the banking industry has changed quite a bit: With automated teller machines (ATMs) and then online banking, the need for physical bank branches has been considerably reduced. This explains the decline in the United States. Furthermore, the level of banking competition, the geographic distribution of the population, and other factors can also influence these numbers and make cross-country comparisons difficult. Thus, some conjunction of special circumstances has caused Mongolia to have the second-highest concentration of bank branches in the world, just behind Luxembourg.

Finally, why is this statistic not growing in Nigeria? The continent of Africa has its challenges, especially in rural areas. However, cell phones have become an unexpected source of financial development, not only through “traditional” mobile banking, but also by using phone minutes as currency for online transactions. This reduces the need for physical bank branches.

How this graph was created: Search for “Mongolia bank branches” and click on the result. Open the graph, click on “Edit Graph,” open the “Add Line” tab, and search for “United States bank branches.” Repeat for Nigeria.

Suggested by Christian Zimmermann.

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