Frank A. Schmid

English

Research Papers in Economics

December 2003
MonetaryTrends
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
Does the TIPS Spread
Overshoot?
When 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 communi-
cation, 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 markets.
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 near-expiration 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 mar-
ket 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 regres-
sion 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 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.
—Frank A. Schmid
Available on the web at research.stlouisfed.org
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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. 

Does the TIPS spread overshoot?

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Does the TIPS spread overshoot?

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Research Papers in Economics