Breakeven inflation

What Is Breakeven Inflation?

Breakeven inflation is a market-derived measure of the average annual inflation rate expected over a specific period. It is calculated by comparing the yield of a nominal bond, such as a traditional Treasury bond, with the yield of an inflation-protected bond, specifically a Treasury Inflation-Protected Security (TIPS), of the same maturity. This concept falls under the broader category of Fixed Income Analysis, providing insights into market participants' expectations for future price changes.⁶⁸, ⁶⁹

The breakeven inflation rate indicates the inflation level at which an investor would achieve the same total return from holding either a nominal bond or a TIPS over their shared maturity period.⁶⁶, ⁶⁷ It is widely used by economists, investors, and policymakers as a forward-looking indicator of market sentiment regarding future price stability.⁶³, ⁶⁴, ⁶⁵

History and Origin

The concept of breakeven inflation gained prominence with the introduction of inflation-indexed bonds. While early forms of inflation-indexed bonds date back to 1780 in the Commonwealth of Massachusetts to protect soldiers' pay during the Revolutionary War, the modern global market for these securities originated in the United Kingdom in 1981.⁶²

In the United States, Treasury Inflation-Protected Securities (TIPS) were first auctioned in January 1997.⁶⁰, ⁶¹ The U.S. Treasury Department introduced TIPS to offer investors protection against inflation and potentially reduce the government's long-term financing costs.⁵⁸, ⁵⁹ With the availability of both nominal Treasury securities and TIPS, the financial markets gained a direct way to infer inflation expectations by comparing their yields, thus giving rise to the breakeven inflation rate as a key indicator.⁵⁶, ⁵⁷

Key Takeaways

• Breakeven inflation is the difference between the yield of a nominal bond and an inflation-protected bond of the same maturity.⁵⁴, ⁵⁵
• It serves as a market-based indicator of the average annual inflation rate expected by investors over the bond's life.⁵², ⁵³
• A higher breakeven inflation rate suggests market expectations for higher future inflation, while a lower rate indicates expectations of lower inflation.⁵¹
• Policymakers and investors use breakeven inflation to gauge market sentiment on price stability and inform investment strategies.⁴⁹, ⁵⁰
• Factors like liquidity and inflation risk premiums can influence the breakeven inflation rate, causing it to deviate from "true" inflation expectations.⁴⁷, ⁴⁸

Formula and Calculation

The breakeven inflation rate is straightforwardly calculated as the difference between the nominal yield and the real yield of two bonds with identical maturities and similar credit risk, typically U.S. Treasury securities.⁴⁶

The formula is:

Where:

• Nominal Bond Yield: The yield on a standard bond that pays a fixed interest rate not adjusted for inflation.⁴⁵
• Inflation-Protected Bond Yield: The yield on an inflation-linked bond (e.g., TIPS) which adjusts its principal and interest payments based on changes in a price index, effectively providing a real return.⁴³, ⁴⁴

For example, the 5-year breakeven inflation rate is derived from the yield of a 5-year nominal Treasury security and a 5-year TIPS.⁴²

Interpreting the Breakeven Inflation

Interpreting the breakeven inflation rate involves understanding what the market collectively anticipates for future inflation. When the breakeven inflation rate is positive, it indicates investors' anticipated level of inflation.⁴¹ For instance, if the 10-year breakeven inflation rate is 2.5%, it suggests that investors expect inflation to average 2.5% annually over the next decade.⁴⁰

Investors often compare the current breakeven inflation rate to their own expectations or to the central bank's inflation target. If an investor believes actual inflation will exceed the breakeven rate, TIPS might be considered a more attractive investment than nominal Treasuries, as they offer protection against rising prices. Conversely, if inflation is expected to be lower than the breakeven rate, nominal Treasuries may be preferred.³⁹

However, it's crucial to note that breakeven inflation is not a perfect forecast of future inflation. It can be influenced by factors such as an inflation risk premium (compensation investors demand for inflation uncertainty) and a liquidity premium (reflecting the relative ease of trading, as TIPS markets can be less liquid than nominal Treasury markets).³⁶, ³⁷, ³⁸ These premiums can cause the breakeven rate to either overstate or understate actual inflation expectations.³⁴, ³⁵

Hypothetical Example

Consider an investor evaluating two hypothetical 5-year U.S. Treasury securities:

• A 5-year nominal Treasury bond with a nominal yield of 3.00%.
• A 5-year Treasury Inflation-Protected Security (TIPS) with a real yield of 0.75%.

To calculate the breakeven inflation rate for these securities:

This result of 2.25% indicates that, based on current market pricing, investors expect the average annual inflation rate over the next five years to be approximately 2.25%. If actual inflation averages exactly 2.25% over the five years, both bonds would provide the same real return. If inflation averages higher than 2.25%, the TIPS would likely outperform the nominal bond, providing better purchasing power protection. If inflation averages lower, the nominal bond would likely be more advantageous.

Practical Applications

Breakeven inflation rates are a vital tool in various aspects of financial markets and economic analysis:

• Investment Decisions: Investors use breakeven inflation to inform their choices between nominal bonds and TIPS, particularly when constructing a portfolio. If an investor's personal inflation outlook differs significantly from the breakeven rate, it can guide decisions on allocating capital to inflation-protected assets.³³
• Economic Forecasting: Central banks, such as the Federal Reserve, monitor breakeven inflation rates as a market-based measure of inflation expectations. This data provides insights into how market participants perceive future price trends, which is critical for formulating and evaluating monetary policy decisions.³¹, ³² The Federal Reserve Bank of St. Louis, through its FRED database, provides historical data on various breakeven inflation rates, including the 5-Year and 10-Year Breakeven Inflation Rates, which are widely tracked.²⁹, ³⁰ These rates help gauge public confidence in central bank targets and influence decisions about corporate investment and household consumption.²⁷, ²⁸
• Risk Management: For institutions with inflation-linked liabilities, such as pension funds, understanding breakeven inflation helps in hedging strategies to mitigate inflation risk.²⁶ It allows them to assess the cost of protecting against future inflation.
• Business Planning: While more commonly used in bond markets, the broader concept of breakeven analysis (which breakeven inflation is a specific application of) helps businesses determine the sales volume needed to cover costs. Similarly, understanding anticipated inflation from breakeven rates can inform pricing strategies and cost projections in business operations.²⁴, ²⁵

Limitations and Criticisms

Despite its utility, breakeven inflation has several limitations and criticisms:

• Not a Pure Inflation Expectation: The most significant criticism is that the breakeven inflation rate is not solely a measure of expected inflation. It also includes an inflation risk premium and a TIPS liquidity premium.²², ²³ The inflation risk premium compensates investors for the uncertainty that actual inflation might deviate from expectations, while the TIPS liquidity premium accounts for the fact that TIPS are generally less liquid (harder to buy and sell quickly without impacting price) than nominal Treasury securities.²⁰, ²¹ These premiums can cause the observed breakeven rate to be higher or lower than the market's true inflation expectations. Research from the Federal Reserve Bank of San Francisco has specifically highlighted the impact of the TIPS liquidity premium on breakeven inflation rates.¹⁸, ¹⁹
• Market Imperfections: The calculation assumes efficient markets where both nominal bonds and TIPS are priced purely on their expected returns and inflation protection. In reality, supply and demand dynamics, market sentiment, and other non-fundamental factors can influence bond prices and, consequently, the breakeven rate.¹⁷
• Deflation Protection: TIPS include a deflation floor, meaning investors are guaranteed to receive at least their original principal at maturity, even if cumulative deflation occurs. This embedded option can distort the breakeven inflation rate, particularly during periods of deflationary fears, by making TIPS relatively more attractive and thus potentially lowering their real yield, which in turn could inflate the breakeven rate.¹⁶
• Short-Term Volatility: Breakeven rates can exhibit short-term volatility due to transient market movements or shifts in risk sentiment, which may not reflect fundamental changes in long-term inflation expectations.¹⁵

Breakeven Inflation vs. Inflation Expectation

While often used interchangeably, "breakeven inflation" and "inflation expectation" are distinct concepts, though closely related.

Breakeven inflation is a market-based metric derived from the difference in yields between nominal bonds and inflation-protected bonds of the same maturity. It represents the specific rate of inflation at which the total return of the two types of bonds would be equal.¹³, ¹⁴ It is an observed market price.

Inflation expectation, on the other hand, refers to the anticipated rate of inflation that consumers, businesses, and investors believe will prevail in the future.¹¹, ¹² This can be derived from various sources, including surveys (e.g., consumer sentiment surveys, professional forecaster surveys) or inferred from financial market data like the breakeven inflation rate.

The key difference lies in the components of the breakeven rate. As discussed in the Limitations section, breakeven inflation encapsulates not only the market's pure inflation expectation but also an inflation risk premium and a TIPS liquidity premium.⁹, ¹⁰ Therefore, the breakeven inflation rate is a proxy or indicator of inflation expectations, but it is not a direct, unbiased measure of those expectations due to these embedded premiums. When analysts refer to "true" or "pure" inflation expectations, they often attempt to strip out these confounding factors from the observed breakeven inflation rate.

FAQs

What does a high breakeven inflation rate indicate?

A high breakeven inflation rate suggests that financial markets anticipate a higher average annual rate of inflation over the bond's maturity period.⁸ This could be due to factors such as strong economic growth expectations, increased government spending, or concerns about rising commodity prices.

How does the Federal Reserve use breakeven inflation?

The Federal Reserve and other central banks monitor breakeven inflation rates as an important market-based gauge of inflation expectations.⁶, ⁷ This information helps them assess the credibility of their monetary policy and determine appropriate actions to achieve their inflation targets and maintain price stability.⁵

Is breakeven inflation a perfect predictor of future inflation?

No, breakeven inflation is not a perfect predictor of future inflation. While it provides valuable insights into market expectations, it is influenced by other factors such as the inflation risk premium (compensation for inflation uncertainty) and the liquidity premium associated with Treasury Inflation-Protected Securities (TIPS). These factors can cause it to diverge from actual future inflation or pure inflation expectations.³, ⁴

What are Treasury Inflation-Protected Securities (TIPS)?

Treasury Inflation-Protected Securities (TIPS) are a type of U.S. Treasury bond whose principal value adjusts with changes in the Consumer Price Index (CPI). This adjustment protects investors from inflation, ensuring that their principal maintains its purchasing power over time.¹, ² They are crucial for calculating breakeven inflation rates.