One way to determine inflation expectations is to take the treasury or nominal yield (not inflation adjusted) and subtract the TIPS or real yield (inflation adjusted). The difference of the two is the expected inflation.

Nominal Yield (minus) TIPS = Inflation expectation

The chart below shows inflation expectations across various maturities using the above formula.

Inflation Expectations

A few interesting points to make from the data

A few months prior to the end of QE1 in the Spring of 2010, inflation expectations began to come down. The same time economic data was pointing towards a double dip recession.

By the summer of 2010 after QE1 was completed inflation expectations had fallen on average from 2.2% to 1.7% That is when the Fed began to "fear deflation."

QE2 was then announced and inflation expectations moved above the highs during QE1 and currently stand at 2.6%, well above the Fed's target of 1-2%.

In April 2010 inflation expectations peaked and it is quite possible assuming QE2 does end in June that the same is happening this April. The Fed could use the cover of lower inflation expectations before formally launching QE3 and if history repeats itself they will only need a few months. Considering the wall the US economy hit this past month, that may be more than it can handle this summer.

By Tony Pallotta

http://macrostory.com/

Bio: A Boston native, I now live in Denver, Colorado with my wife and two little girls. I trade for a living and primarily focus on options. I love selling theta and vega and taking the other side of a trade. I have a solid technical analysis background but much prefer the macro trade. Being able to combine both skills and an understanding of my "emotional capital" has helped me in my career.

© 2011 Copyright Tony Pallotta - Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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