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Inflation Index Bonds According to opinion of numerous financial analysts and market participants, the extraordinary volatility of the financial markets, current disturbance in the American financial system and possible prognoses concerning increase of inflation are the issues of todays US financial market. However, not all market participants consider that inflation will impose a significant threat to American financial markets. For example, William Poole in his article Is Inflation Too Low? considers that the financial upset will clearly disappear as the markets settle down in due time. According to his opinion, inflation will have no significant damage to the U.
S. economy (Poole, 1999). This optimism results from the economy's strong initial conditions of low inflation, low and stable inflation expectations, and a well-capitalized banking system (Poole, 1999). I agree with him, because this is a perfect set of initial conditions that are very favorable for American economy. There is an argument that economy works better in case there is a moderate inflation reaching 2 - 3 percent per year. According to this point of view, there are two main explanations of 2 - 3 percent inflation.
First of all, it bases on argument that inflation makes operation of labor markets easy and smooth. By doing that, it is conductive to maximum employment in the face of nominal wage rigidity (Poole, 1999). The second argument claims that inflation, via the Fisher relationship, keeps nominal interest rates from falling too close to the zero bound (Poole, 1999). In result of this, it cuts rates. William Poole disagrees with this argument and explains that a zero-inflation monetary regime, sustained over the long run, would enhance an economy's performance (Poole, 1999). He also says that inflation and relative price variability are linked and considers that the position of our government is quite strong.
He is confident that our economy's long-run performance would be enhanced by a monetary policy that aims at, achieves and maintains a zero rate of inflation. Another economist, Milton Marquis, Senior Economist, FRBSF, and Professor of Economics (Florida State University) also considers that something should be done in order to keep inflation rate at its flat level approaching zero. He dwells on 2 % inflation solution and other possibilities that will be able to keep economy's performance on its top level (Marquis, 2001 - 03). Here is the table that presents information on recent Government bonds: Maturity TIPS Regular Bond Date
Yield
Yield to Maturity
Jan 2008
0. 737 %
3. 410 %
Jan 2009
0. 849 %
3. 530 %
Jan 2010
0. 974 %
3. 640 %
Jan 2011
1. 097 %
3. 750 %
Jan 2012
1. 236 %
3. 860 %
Jan 2014
1. 479 %
4. 040 %
Jan 2025
1. 789 %
4. 540 %
Jan 2028
1. 794 %
4. 540 %
Jan 2029
1. 785 %
4. 530 %
Jan 2032
1. 701 %
4. 460 % TIPS are Treasury Inflation Protected Securities.
They can provide us with an accurate measure of long-term market inflation expectation. The yield difference can be examined as a measure of future market inflation expectation, but it gives us an approximate account because of the large and variable liquidity premium on TIPS (Shen, Pu; Corning, Jonathan, Fourth Quarter 2001). However, it is quote reliable instrument to measure future index of inflation. TIPS were introduced by the U. S. treasury and present debt instruments, the payoff of which are tied to the inflation rates during the lives of the instruments (Shen, Pu; Corning, Jonathan, Fourth Quarter 2001).
TIPS are aimed to protect the investors from the risk of unexpected inflation (Shen, Pu; Corning, Jonathan, Fourth Quarter 2001). According to this table, yield spread gives us an accurate measure of expected inflation. It is calculated by formula where is the nominal yield on a 10 -year conventional Treasury, is the real yield on a 10 -year conventional Treasury, and is the average of market participants expected rates of future inflation for the next ten years (Shen, Pu; Corning, Jonathan, Fourth Quarter 2001). Although it is very difficult to make precise prognoses concerning inflation, the table shows us that the rate of inflation will be low. (Charles T.
Carlstrom, Timothy S. Fuerst, November 2004) According to the results derived from the table, we can see that the yield spread can be examined as a reliable measure of expected inflation and is a better measure of expectations of market inflation than survey forecasts and other financial prognoses. Besides, the stability of the U. S. economy allows us making prognosis that the inflation rate will be low over the next few years. Bibliography Charles T.
Carlstrom, Timothy S. Fuerst. (November 2004). Expected Inflation and TIPS. Federal Reserve Bank of Cleveland: web Marquis, M. (2001 - 03, February 2).
Inflation: The 2 % Solution. Retrieved January 3, 2007, from Federal Reserve Bank of San Francisco: web Poole, W. (1999, July/August none). Is Inflation Too Low? Retrieved January 3, 2007, from web web Shen, Pu; Corning, Jonathan. (Fourth Quarter 2001).
Can TIPS help identify long-term inflation expectations? Kansas: Federal Reserve Bank of Kansas City - Economic Review.
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