Inflation or disinflation? Evidence from maturing US Treasury Inflation-Protected Securities

The prices of maturing US Treasury Inflation-Protected Securities (TIPS) during the last 6-month coupon period reveal whether the market is anticipating an inflationary or disinflationary regime. Against the benchmark of the Treasury bill yield to adjust for the time value of money, maturing TIPS prices represent a sequence of updated forecasts of the consumer price index (CPI) to be used to determine the final single cash flow on the maturity date. Under the assumption of risk-neutrality, the sequence of forecasts is modelled as a martingale. Generalized method of moments and regression analysis are used to test two martingale properties of the CPI forecasts: (1) the unconditional mean of daily changes in the CPI forecasts is zero and (2) serial correlations of the daily changes in the CPI forecasts are zero. The test statistics reject both martingale properties of the CPI forecasts implied in maturing TIPS prices. A persistent upward movement of the CPI forecasts toward the actual target CPI during the first quarter of 2002 implies the market was then anticipating a disinflationary regime. One policy implication is that time series behaviour of CPI forecasts can provide timely feedback to the Federal Reserve Open Market Committee.