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short essays and reports on the economic issues of the day
2003 ■ Number 28

Does the TIPS Spread Overshoot?
Frank A. Schmid


of the rate of expected inflation with updates of the actual rate
of inflation. For every month during the period January 1999
through September 2003, we measure the logarithmic change
in the average rate of inflation over the previous 10 years and
the logarithmic change in the constant-maturity 10-year TIPS
spread. Changes in the TIPS spread—and thus measured inflation expectations—are well aligned with actual changes in the
rate of inflation when updates of the markets’ forecast of the
future average rate of inflation and updates of the past average
rate of inflation are of similar size. In fact, we find that the sum
of the absolute values of logarithmic changes of the expected
rate of inflation is 7.4 times the sum of actual logarithmic
changes in the 10-year average rate of inflation. It seems then
that inflation expectations, at least as judged by the yield spread
between nominal and inflation-indexed Treasury securities,
tend to overshoot. ■

Change in Expected Rate of Inflation (Percentage Points)

hen making monetary policy decisions, the Federal
Reserve looks to financial markets for information
about the state of the economy and their expectations of monetary policy actions. For instance, the difference
in yields between nominal and inflation-indexed Treasury
securities—the TIPS spread—tells the Federal Reserve about
the average rate of CPI-U inflation the markets expect for the
time to maturity of these securities. (CPI-U is the consumer
price index for all urban consumers.) Similarly, the federal
funds futures market offers the Federal Reserve a reading of
the markets’ expectations about the path of the federal funds
rate over the next few months. Clearly, through communication, the Federal Reserve tries to offer the markets some guidance about its intentions. Yet, decisions on monetary policy
actions are not finalized before the Federal Open Market
Committee (FOMC) actually meets. It is thus almost inevitable that, on occasion, the Federal Reserve will surprise the
It is interesting to know how the TIPS spread—the markets’ gauge of the expected rate of inflation—responds to
surprises in monetary policy actions and whether these
responses are sensible in magnitude. The chart plots, for the
period January 1999 through September 2003, surprises in
monetary policy actions against changes in the TIPS spread.
Surprises in monetary policy actions—that is, in the federal
funds rate target—are measured by the price change of nearexpiration federal funds futures contracts on days of scheduled FOMC meetings and on days of unscheduled, intermeeting monetary policy actions. The regression line in the
chart, which was generated using a technique that is robust
to outliers, is downward sloping. This suggests that monetary policy actions influence market participants as follows:
tighter-(easier)-than-expected actions lead market participants to expect a lower (higher) average rate of inflation over
the next 10 years, as reflected in the TIPS spread. (The author
confirmed the statistical significance of this finding in a
more comprehensive regression approach and for alternative
measures of the TIPS spread.)
Are changes in inflation expectations after monetary
policy surprises of similar size as actual changes in the rate
of inflation? To answer this question we compare updates











Surprise Monetary Policy Action (Percentage Points)
NOTE: The surprise component of the FOMC decision on the federal funds target rate is
measured by the price change in the respective month’s federal funds futures contract,
adjusted for the number of calendar days remaining for the month. If the FOMC policy
action happened within the last seven days of the month, the price change of next
month’s federal funds futures contract was used.

Views expressed do not necessarily reflect official positions of the Federal Reserve System.