Deriving an Assumption on Inflation
While our assumption on inflation comes down to a judgment call in the end, we take a thoughtful approach to balancing the information coming from what we believe to be the best sources of data.
Expected annual inflation is a key assumption used by our retirement savings and withdrawal advice, which help you plan for the future. To make these calculations, we must assume a specific growth rate for investments, but the rate of return that really matters is the “real” rate of return—i.e. the return adjusted for inflation. This is because the prices of everything that you buy tend to increase over time, so if you want to maintain the same ability to spend, your plans must take into account the fact that goods and services will cost more in the future.
An example from Investopedia (that we have revised a bit) helps to illustrate this concept. Say you have $20,000 and want to buy a car that costs this same amount. Instead of purchasing the car now, you could decide to wait and invest the money for 1 year so as to have a cash cushion after buying the car. Assuming that you can earn 5% interest over a 12-month period, you will have $21,000 in one year. So it seems as if you can generate $1000 in savings by delaying your purchase for one year. But say inflation on car prices over the same one-year period is 2%. That same car will cost $20,400 in one year. The actual amount of money that remains after you purchase the car will be $600, i.e., 3% of your initial investment of $20,000. Your purchasing power due to investing only increases by $600 instead of $1000. 3% is indeed your real rate of return as it accounts for the effects of inflation.
Multiple factors can drive the inflation rate including economic growth, public policy, and monetary policy. As a result, no one knows with certainty how the prices of the broad set of goods and services that you purchase will increase in the future. There are many different, credible sources of data for developing views on how inflation will evolve over time. No one source is necessarily going to give you the “right” answer so it is important that you use the multiple sources of information that will help you filter signal from noise.
While our assumption on inflation comes down to a judgment call in the end, we take a thoughtful approach to balancing the information coming from what we believe to be the best sources of data. These sources include:
- Forward guidance from the Federal Reserve
- Market expectations derived from the pricing of US Treasuries and Treasury Inflation Protected Securities (TIPS).
Customers with differing views on inflation can also override our assumption via the Edit Assumptions panel, which can be found on the Plan tab of a Retirement goal.
We discuss each of these sources as well as our overall thought process in more detail below, but our broad conclusions based on the present state of the data are as follows:
- The Federal Reserve explicitly aims for an annual inflation rate of 2% over time and has demonstrated effectiveness in keeping inflation anchored to this level.
- Macroeconomic projections from the Fed also indicate that long-term inflation forecasts remain near 2% if not below this level.
- As of May 2, 2017, almost all inflation expectation measures derived from market prices suggest that the market expects inflation to be below 2% across multiple short- and long-term horizons. Since these measures are volatile, we will be keeping a close eye on how market expectations evolve going forward, but inflation expectations seem to be well- contained at the moment.
Based on all of these sources, we assume a 2% rate of inflation in our financial planning calculations.
The Target Inflation Rate
The Federal Reserve explicitly states that an inflation rate of 2 percent is most consistent with their mandate for price stability and maximum employment over the long-run.1 But what data are Fed officials using to evaluate ongoing inflation trends? While they monitor multiple measures of inflation, it is widely recognized that the Fed prefers to use the core Personal Consumption Expenditures (PCE) index.2 This core measure strips out volatile components such as food and energy, allowing the Fed to better gauge long-term trends. Note that the monthly, year-over-year percent change in core PCE, a commonly used measure of inflation, has been strongly anchored to 2% since the early 1990s. Through its implementation of monetary policy—the process of raising or lowering the costs of borrowing through the U.S. federal funds rate—the Fed has demonstrated effectiveness in anchoring the long-term inflation rate to 2%.3 Accordingly, at Betterment we account for this trend and model inflation to remain stable for the foreseeable future.
PCE Core Inflation
Source: Federal Bank of St. Louis FRED, author's calculations
However, we recognize that inflation target changes are possible as a result of macroeconomic conditions, political climate, public policy and Fed policy. Indeed, the 2% explicit inflation target itself is relatively new (introduced by Ben Bernanke in January of 2012).4 To address this possibility and help ensure our inflation expectations remain as accurate as possible, we monitor both forward inflation projections and implied inflation rates from the fixed income securities markets.
Forward Fed Projections
The Fed distributes their macroeconomic projections to the public on each FOMC meeting date (just hours after). These reports include information about the distribution of projections across all 17 Federal Open Market Committee (FOMC) participants for real GDP growth, the overall inflation rate, overall PCE inflation, core PCE inflation and the Fed Funds rate. The median and central tendency5 forecasts for one, two, and three years ahead as well as longer-term are provided. The ranges on the forecasts one, two, and three years ahead are also provided. An example of the Fed report from the March 2017 FOMC meeting is shown below. We monitor these reports closely and focus on any significant changes in projections for PCE and core PCE inflation in particular for any indication that we need to be adjusting our views accordingly. At present, inflation projections are tame with the relevant inflation statistics all near 2% and below this level in many cases.
Forward Fed Projection Table
Source: Federal Reserve Board
Inflation Breakeven Rates
Given pricing in the TIPS and US Treasury markets, we can derive the market's expectation for inflation at different horizons. This expectation is often referred to as the breakeven inflation rate. For a given maturity, the breakeven inflation rate is the difference between the yield on a US Treasury note (bond) and the yield on an inflation-protected US Treasury security (also known as TIPS) with the same maturity. If we perform this calculation for a 5-year maturity, for example, we get the market's expectation for inflation over the next five years. How does this make sense as an expectation for inflation? The cash flows on TIPS are tied to the Consumer Price Index (CPI), another common gauge for inflation. The principal on TIPS rises with CPI while the coupon rate represents a real return (i.e., return above inflation). To the extent that the semi-annual coupon payments and the final redemption value of TIPS track increases and decreases in CPI, investing in TIPS serves as a perfect hedge against inflation. In contrast, US Treasury bonds are fully exposed to inflation risk. Thus, the yield spread of a US Treasury bond over TIPS with the same maturity—often referred to as the TIPS spread—represents the premium an investor demands for being subjected to the risk of inflation in the future.
The markets, in fact, give us a term structure of inflation expectations as shown below.
Term Structure of Expected Inflation Rates
Source: US Treasury; author's calculations
This gives us the market's expectation for future inflation over 5-year, 7-year, 10-year, 20-year, and 30-year horizons. We see that only the breakeven inflation rate for the 30-year horizon is just north of 2% as of 2017-05-02.
Since breakeven inflation rates are based on a pricing measure that changes regularly, they can provide an early indicator of meaningful increases in inflation. But as appealing as these market-based measures might be, they are not without their drawbacks and therefore cannot serve as the sole basis for formulating our inflation assumptions. For one, breakeven inflation rates reflect factors that may have nothing to do with long-term inflation expectations. For example, TIPS are not as liquid as plain vanilla US Treasuries and their yields may, therefore, have an embedded liquidity premium. Changes in risk appetite which cause nominal Treasury yields to rise and fall can also influence the TIPS spread. Additionally, regardless of maturity, whether 5-year, 7-year, 10-year, 20-year or 30-year, inflation expectations based on the TIPS spread are volatile as clearly shown below. Our goal is to forecast long-term inflation and we do not want to get whipped around by transitory changes in market expectations. We would need to see sustained and persistent increases in breakeven inflation rates above 2% across the term-structure before we would consider an increase in our long-term expected inflation assumption.
Expected Inflation Rates Across All Available Maturities
Source: US Treasury
5-year, 5-year Forward Inflation Expectations Rate
Another long-term measure of the market's expectations for inflation expectations is the 5-year, 5-year forward inflation expectations rate. This is a measure of what the market expects inflation to be over a 5-year period five years from now. In other words, it is an inflation breakeven rate that, as shown in the figure below, applies to the five-year period starting five years from the respective dates in the x-axis. This market-based measure of long-term inflation expectations is preferred by the Fed as it is less sensitive to cyclical factors like energy prices. It, therefore, gives a better indication of whether the market thinks that the Fed is meeting its goal of long-term price stability. Currently, this measure suggests an expected inflation rate of under 2%. This market-based measure is also volatile and is just one additional source of information about inflation rates that we watch.
5-year, 5-year Forward Inflation Expectations Rate
Source: Federal Bank of St. Louis FRED
Long-term historical trends suggest that the Fed has been very effective at keeping the long-term inflation rate anchored at 2%. Current Fed projections show that policymakers are not anticipating that this will change anytime soon. Furthermore, almost all market-based measures currently indicate that inflation expectations fall below the Fed’s 2% target and we would need to see more sustained deviations above this target level before changing our expected inflation assumption. For all these reasons, we assume a 2% inflation rate in our financial planning models and research.
2 See https://www.federalreserve.gov/faqs/economy14419.htm and https://en.wikipedia.org/wiki/Coreinflation for more on this preference.
3 See https://research.stlouisfed.org/publications/review/12/01/65-82Thornton.pdf for a historical perspective on this.
5 The sample mean, excluding the three highest and three lowest projections.