Using inflation-linked bonds to forecast inflation? Beware – new research suggests they are only decent predictors in the short-term. Over long horizons, the relationship is actually negative:

We showed that the break-even inflation is informative about future inflation over horizons of 3, 6, 24 and 30 months. For the 3- and 6-month horizons, besides being informative, break-even inflation is an unbiased estimator as well. However, over the horizons of 24 and 30 months, the relationship between the break-even and future inflations is negative. On the other hand, for the horizons of 12 and 18 months, breakeven inflation has almost no power to explain future inflation.

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This does not look good, says David Beckworth: the US market expects aggregate demand to fall, and if the Fed does not act to stabilise the fall in spending, it will act as an effective tightening of monetary policy.

His logic? Markets’ expectations of inflation fell in the first half of this year as shown by the falling yield spread between inflation-protected and regular bonds (see chart). Productivity growth – which could have explained it – also appears to be falling. “That leaves us with one troubling possibility: the market is expecting aggregate demand to decline going forward.” Read more