Inflation Expectations

Inflation expectations are the market's forecast of future inflation rates. They are a critical component of nominal bond yields and a key input to monetary policy decisions.

Nominal yields can be decomposed as:

Nominal yield = Real yield + Expected inflation + Inflation risk premium

Two primary measures of inflation expectations:

• Breakeven inflation rate: the yield spread between a nominal Treasury and a TIPS of the same maturity. The 10-year breakeven reflects the market's expectation of average annual CPI inflation over the next decade.
• Survey-based expectations: the University of Michigan consumer survey and the New York Fed's Survey of Consumer Expectations track household inflation expectations.

Inflation expectations matter for the yield curve because:

• Well-anchored expectations (stable around 2%) allow the Fed to adjust policy without triggering self-fulfilling inflation spirals
• Rising expectations force the Fed to tighten, pushing up front-end yields and often flattening the curve
• Falling expectations (disinflation risk) allow the Fed to ease, typically steepening the curve

The blog post "Is Gold a Stock-Bond Diversifier?" explores how inflation expectations drive asset correlations — when inflation expectations rise, stocks and bonds tend to sell off together (positive correlation), breaking the diversification benefit that characterizes low-inflation environments.

The distinction between expected inflation and the inflation risk premium (extra compensation for inflation uncertainty) is important but hard to disentangle without a model.