Deriving Inflation Expectations from Nominal and Inflation-Indexed Treasury Yields

Abstract

This article derives a measure of inflation compensation from the yields of a Treasury inflation-indexed security and a portfolio of STRIPS that has similar liquidity and duration as the indexed security. This measure can be used as a proxy for inflation expectations if the inflation risk premium is small. Calculations suggest that the rate of inflation expected over the next ten years fell from just under 3% in mid-1997 to just under 13/4% by early 1999, before returning to about 21/2% by the beginning of 2000. This variation is more extensive than would have been expected from a simple model of inflation dynamics or from a survey measure of long-run inflation expectations.