Tuesday, August 21, 2012

Key Indicator of Prior Quantitative Easings

There continues to be talk as to whether the Fed will implement another round of quantitative easing in the coming months (QE3).  What indicator should one watch to determine if QE3 is on the way?  Here's a chart of the break-even inflation rate on five-year treasuries:

Break-even inflation is the difference between the yield on the five-year US Treasury bond and the five-year TIPS (Treasury inflation protected security).  The yield on TIPS represent the interest earned apart from inflation, to which enough interest to cover inflation is added to one's return.  The difference between traditional Treasuries and TIPS is the amount of inflation necessary to result in an equal yield between the two securities (break-even inflation).  It gets a little complicated, but expected inflation is less than break-even inflation since an inflation risk premium is implicitly part of break-even inflation.

Back to the main point.  one of the Fed's main goals is to keep inflation at about 2% (that's it's inflation target).  You'll notice two periods during which break-even inflation declined significantly.  Of course the first time was at the depths of the financial crisis in late 2008, when break-even inflation collapsed to -2%.  The collapse in inflationary expectations was one reason the Fed engaged in the first round of quantitative easing.  The second instance was not as dramatic, but took place in the summer of 2010.  After reaching a short-term peak of about 2% earlier in 2010 (2.16% in January, 2.01% on April 30), break-even inflation experienced a significant decline to 1.22% in late August.  What stopped the decline?  Break-even inflation bottomed out and began to rise when Ben Bernanke laid the groundwork for QE2 at a speech in Jackson Hole, Wyoming.  Thus, both QE1 and QE2 were preceded by market perceptions of deflation or that inflation would be exceedingly low.  Does that exist today?  As the chart shows, break-even inflation is relatively stable (about 1.9%), indicating that QE3 is unlikely at this time according to this indicator.