The European Central Bank recently decided to raise its core benchmark rate by 25 basis points presenting a slightly more hawkish view than the United States’ own supportive monetary stance.

The fundamentals across both markets are clearly different and, given the recent inflation pushes in the UK, it is understandable that Trichet is setting the ECB back within its own more restrictive mandate of inflation-control (as opposed to the Fed’s broader outlook on inflation and employment).

But Are Inflation Expectations Really Heading Higher?

Again, it is important to separate the factors affecting the European Monetary Union area with the economic factors covered by the Federal Reserve.

The US Fed’s preferred market metric in describing inflation expectations is the 5 year TIPS to treasuries break-even rate, a graph of which is available below. As the chart shows, there’s been some slight uptick over the course of February and March with resistance at the 3% level.


Data from Bloomberg, FED5YEAR:IND, Federal Reserve Forwad Breakeven Rate

Some debate still surrounds the reliability of the TIPS to treasury yield differential, in part, due to the relative liquidity premium existing between both securities. However, if one considers that the liquidity premia (or lack thereof) may be constant, then one could state that moves across the break even rate still represent shifts in market expectations.

Other Possible Signals to Shifts in Core Inflation

The previous chart depicted one possible market measure over inflation expectations but beyond the issue of expectations is the other substantive problem of actual inflation realisation. I was unable to obtain a raw data set over the FED 5 year break even rate in order to measure it back with actual core CPI measures but did obtain, courtesy of the St. Louis Fed Research branch, some core data over the 5 year Fixed for Floating swap spread.

Historical CPI and Core Measures

The following two charts present a quick ten year historical with CPI measures (percentage change from a year ago) at a broad level and then at the more core base that excludes food and energy prices.


CPI Broad Basket, Monthly Readings 2001 to 2011; source St. Louis Fed.


CPI Excluding Food and Energy, Monthly Readings 2001 to 2011; source St. Louis Fed.

5 Year Fixed For Floating Swap Rate

The following chart, provides data over 5 year fixed for floating swap rates, which, though not necessarily entirely derived from inflation measures, should still price across some level of inflation duration across to their holders.


5 Year Fixed For Floating Swap Rate; Data From St. Louis Fed.

Linear Visualisations

At this point, your eyes should have jumped to some level of affinity between the 5 year swap chart and the core CPI measures. But just to illustrate this a bit further, I’ve provided the following analysis with all data sets matched at a monthly base level.


CPI exc. Food & Energy Vs. 5 years Fixed For Floating Swap Rate

Some Quick Analysis…

The correlation between the core CPI and the 5 years fixed for floating seems to hold visually and does offer a light model between market pricing and core CPI measures.


Correlation Graph Between Core CPI and 5Yrs Fixed to Floating Swap Rate


Linear Regression statistics for 5 Year Swap Rate to Core CPI measures

Clearly, this single factor model still leaves too high a standard error for more stringent applications but it does provide one base over which to view shifts in core CPI separately from shifts in inflation expectations.

Core CPI: Historical Performance And Forecast Figures


CPI excluding Food and Energy VS. Model with March and April 2011 Forecasts

Forecast figures for the above chart were obtained by using averages for March and month-to-date April swap rate data. As the above chart shows, though core inflation is slightly rising, it is still within historical low ranges.

The US CPI figures for March 2011 are due for release this coming Friday, April 15th.

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