Market Measure Of Inflation

Inflation is caused by a relative increase in the money supply. It refers to a general rise in prices measured against a standard level of purchasing power. The Government periodically measures inflation through mechanisms such as the Consumer Price Index (CPI). The CPI measures the current price of a selection of goods purchased by a “typical consumer” versus the price of the same or equivalent goods at a reference date in the past. The CPI is calculated periodically by the U.S. Bureau of Labor Statistics.

In the past century, inflation, as measured by the CPI rate of change, has varied from a high of +18.0 per cent in 1918, to a low of -10.5 per cent in 1921. During the great depression that started in 1929 the lowest (most negative) CPI rate of change was -9.9 per cent, in 1932. Prior to 2009, the most recent year in which the year-to-year CPI rate of change was negative was 1955 (-0.4 per cent). In the post World War II period, the CPI rate of change peaked at +14.4 per cent in 1947, and again at +13.5 per cent in 1980. During the 1985-2008 period, the yearly average CPI rate of change remained in the +1.5 to +5.5 per cent range, but for 2009 it dropped temporarily to -0.35 per cent.

Although the CPI provides a measure of inflation, its calculation by the U.S. Bureau of Labor Statistics is time consuming, as it involves the collection and processing of massive amounts of data. There is a substantial delay (about one or two months) between the start of inflationary or deflationary trends and the publication of CPI statistics first indicating the trend shift. This delay can be reduced by using a current measure of inflation as determined by the free market forces that drive the current yield of Treasury securities.

The United States Treasury offers two types of securities. The existence of standard and inflation-adjusted Government securities makes it possible to determine the Market Measure of Inflation (MMI), that is, inflation as determined by the financial markets.

Standard notes and bonds are debt securities, in which the issuer, in this case the United States Treasury, owes the holders a debt and is obliged to pay back the principal and interest at a later date. United States Treasury bonds are issued for a fixed term longer than ten years. The Treasury issues notes with maturities between one and ten years. The Treasury securities generally have a coupon payment every six months. The principal is returned to the holder at maturity.

Treasury Inflation-protected Securities (TIPS) differ from standard notes in that their interest and principal are adjusted for inflation. At maturity the Treasury redeems the note at its inflation-adjusted value or its original par value, whichever is greater. In all likelihood, inflation will occur over the life of the security and the redemption value will be greater than the original par value. If there were a net deflation over the holding period, the final payment would be the original par value, which means there can be no loss of principal due to deflation.

Semi-annual interest payments for inflation-protected notes are based on the inflation-adjusted principal at the time the interest is paid. Each interest payment is calculated by multiplying the inflation-indexed principal (whether greater or less than the par value) by one-half the coupon rate for that note. Like other notes, TIPS have coupon rates that are derived from the open market bids received by the Treasury. That is, the TIPS coupon is a market rate. If inflation occurs throughout the life of the note, every interest payment will be greater than the previous one. In the event of deflation during a six-month period, the interest payment for that period will decrease.

The current yield of a standard Treasury security includes a market-driven estimate of future monetary inflation. The current yield of inflation-protected Treasury securities approximates the risk-free time value of money. The difference between the current yield of a standard Treasury security and that of an inflation-protected Treasury security is a free-market estimate of inflation.

The Market Measure of Inflation can be easily determined by subtracting the current yield of an inflation-protected Treasury bond or note, of a given maturity date, from the current yield of the corresponding standard Treasury bond or note of the same maturity date.

For example, MMI = current yield of 10-year Treasury note - current yield of 10-year inflation-indexed Treasury note.

See a sample calculation of inflation based on market-driven 10-year Treasury note yields for a period in the past, compared with the CPI rate of change for the same period.

The following tables show calculated Market Measure of Inflation (MMI = Cur Yld - Inf Adj Cur Yld) based on different Treasury note and Treasury bond maturity dates.

Calculation of inflation from current U.S. Treasury note and bond yields for May 7, 2015
Maturity Date Current Yield Inflation Adjusted Current Yield Market Measure of Inflation
5 Year 1.375 0.125 1.250
10 Year 2.000 0.250 1.750
30 Year 2.500 0.750 1.750

Calculation of inflation from current U.S. Treasury note and bond yields for February 3, 2012
Maturity Date Current Yield Inflation Adjusted Current Yield Market Measure of Inflation
5 Year 0.77 -1.28 2.05
10 Year 1.92 -0.25 2.17
30 Year 3.12 0.71 2.41

The current yield of standard and inflation-adjusted Treasury securities is widely available. See Bloomberg Rates and Bonds.

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