Prepared by Oya Celasun, Roxana Mihet (RES), and Lev Ratnovski (RES).
The University of Michigan survey asks consumers about their expectation of average inflation over the next five to ten years, that is, over a horizon that includes the near term. Expected inflation in the longer term—for instance over the five year period that starts five years from now—can be derived from the Treasury inflation protected securities (TIPS) yield curve.
Inflation compensation is defined as coupon minus TIPS yields. It captures inflation expectations and time-varying liquidity and inflation risk premia associated with holding TIPS. We verify that the estimation results are robust to controlling for the time-varying liquidity risk. Liquidity risk is corrected by taking residuals from regressing inflation compensation on two of its proxies: (1) the spread between Treasury bonds and Treasury-backed but less liquid Resolution Funding Corporation bonds, and (2) the volume of TIPS transactions as a share of coupon transactions by primary dealers. We are able to control for liquidity risk only during 2003–08, as measures of liquidity during the crisis were contaminated flight to quality and the Fed’s large-scale asset purchases. Changes in inflation rate risk can be inferred from survey-based data using Kalman filtering, but the approach is not useful for high-frequency data. See the discussion in Gurkaynak et. al., 2010, “The TIPS Yield Curve and Inflation Compensation.” American Economic Journal: Macroeconomics 2(1): 70–92.