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Some Recent Data on Inflation

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Anyone who is the least bit familiar with Index Fund Advisors knows that we take a “no forecasting” approach to economic data and its impact on returns. However, when the market itself provides a forecast, we are happy to make note of it, even though there is no potential to profit from it since it is fully incorporated into current prices. One such example is the anticipated rate of inflation, as measured by the consumer price index. An estimate of the market’s expectation of future inflation can be calculated as the difference between the yields on nominal and inflation-protected (TIPS) Treasury bonds of the same maturity. Performing this calculation on the 5-year bond as of 7/10/2013 yields 1.87% as the market’s “breakeven rate of inflation” which is the rate of inflation at which the purchaser of a 5-year bond is indifferent between the nominal and the inflation-protected bond. The breakeven rate of inflation is actually a little higher than the expected rate of inflation, because it includes a risk premium that the buyers of nominal bonds demand in exchange for bearing inflation risk.

Unfortunately, the true value of the inflation risk premium is unknown. Regardless, the fact that we have an upper bound of the market’s expected rate of inflation at less than 2% should cause us to be highly skeptical of the pundits who forecast abnormally high inflation due to the Federal Reserve program of bond-buying known as “quantitative easing.”

During the second quarter of 2013, contrary to what all the CNBC pundits were expecting, the market actually lowered its inflation expectation by about 0.5%. Although yields on nominal Treasury bonds increased during the quarter, the yields on TIPS increased by a greater extent. This is why TIPS funds took a bigger hit during the quarter than nominal bond funds of similar duration. As we have noted in Step 7: Silent Partners, inflation is one of those insidious costs that affects all investors, and we are happy to see it forecasted by the market to be more than a percentage point lower than its long-term historical average of 3%.

Although there is no potential to profit from the market’s expectation of inflation or other economic indicators, it can certainly help prevent investors from making rash decisions that they will later come to regret. All too often, we have heard statements like “Inflation will go through the roof” or “The U.S. dollar is doomed” that are used to justify major decisions such as selling out of a balanced portfolio. Indeed, there is now a whole genre of financial literature that we refer to as the doomsday books. If the investor conjuring up those bleak scenarios in his mind had simply paused to ask the question, “What does the combined intelligence of all financial market participants tell us about future inflation or currency exchange rates?” he might have realized that there was no need for panic. If, however, he believes that he has special knowledge or insight that the rest of the market somehow missed, then he will probably go ahead with his decision and likely suffer for it. As we have said many times before, Mr. Market charges a high tuition to those investors who need to learn the basic lessons of investing, and one of those  lessons is that when you and the market have contradictory opinions, chances are the market is right and you are wrong.