In recent years, monetary policymakers have monitored several measures of market expectations of future inflation. One of these measures is based on the yield differential between nominal and inflation indexed Treasury securities. This yield spread is also called the “breakeven inflation rate.” An increase in the breakeven rate is sometimes viewed as a sign that market inflation expectations may be on the rise. For example, the FOMC frequently refers to the yield spread as a measure of “inflation compensation” and considers the yield spread an indicator of inflation expectations in policy deliberations. ; Accurately inferring market expectations of inflation from yield spreads is difficult. The difficulty lies in the differences in market liquidity conditions between nominal and inflation indexed Treasury securities. ; Shen presents evidence that liquidity differences between nominal and inflation indexed Treasuries have been nontrivial. Consequently, simply attributing changes in yield spreads to changes in market inflation expectations and ignoring the liquidity risk premium could lead to inaccurate inflation expectations.
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Article provided by Federal Reserve Bank of Kansas City in its journal Economic Review.
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