Tuesday, September 25, 2007

A Jump in Expected Inflation

Jim Hamilton, one of the most astute macroeconomist-bloggers, provides this great graphic. It shows forward inflation compensation during the market trading of Tuesday last week. This measure is based on the spread between nominal bond yields and real (inflation-protected) bond yields. It reflects the market's expectation of future inflation--to be precise, the expectation of the average five-year inflation rate starting five years from now. Click through to the Hamilton link for more details if you are not familiar with this sort of data.

The jump upward at 2 pm occurred just after the Fed's announcement of a surprisingly large cut in its target interest rate. The apparent change in expected inflation is not large--about 5 basis points--but it is striking nonetheless. It shows clearly how easier monetary policy raises expected inflation.