Is the US market really expecting less than 3% yearly inflation over the next 5 years?

Question

Several people in my family are fearful of upcoming high inflation, perhaps due to the relatively high US inflation figures reported in the last few months (8%+). They think that the US inflation rate will be about 8% for the next few years. This prompted me to investigate the yield spread between 5-year Treasury bonds and 5-year Treasury Inflation-Protected Securities (TIPS). This is a chart of the 5-Year Breakeven Inflation Rate obtained from the St. Louis Fed's website:

The spread on 2022-11-07 is 2.67. Does this mean that the market is now expecting inflation to be 2.67% per year over the next 5 years? When I mentioned the 2.67% figure, people in my family were surprised and said that it was "too low". Is it possible that I may be missing something that may affect the interpretation that 2.67% is the expected inflation rate? Is it possible that the true inflation expectations may be higher than what the yield spread is?

Answer 1

The overall answer to your question is: yes, current market prices imply an expected inflation rate over the next 5 years of around 2.67%.

Having said that, the market for TIPS is significantly less liquid than the market for treasuries. As the implied inflation rate is calculated as i - r, where i is the treasury yield and r is the TIPS yield, any noise in r will translate to a noisy estimate of the inflation rate. Both TIPS and Treasuries have seen large price declines this year but since TIPS have poor liquidity, part of this drop could be considered non-fundamental. If indeed TIPS are temporarily underpriced, this would mean r is artificially high and thus the TIPS implied inflation rate too low. A similar dynamic was in play in the financial crises of 2008 and 2020, where as seen in your graph, implied inflation expectations plummeted, more driven by panic selling in TIPS markets than by changing fundamentals.

Inflation swaps arguably suffer from less of this issue, so a forward inflation swap like 2Y2Y or 5Y5Y probably gives a cleaner estimate of future inflation. Still, the implied rate of 2.67% should not be totally discounted. We can safely say that market consensus is not in line with inflation staying at current levels in the medium-term.