Expected inflation

We can assess the effect of the stronger CNY on inflation expectations by mapping the currency against Treasury Inflation Protected Securities (TIPS) breakeven rates of inflation at the five-, 10-, and 30-year horizons.

Why pay attention to TIPS breakevens? Why not concentrate on the much longer and more complete history of reported inflation, such as the Consumer and Producer Price indices (CPI and PPI)? The answer is simple: Economic decisions are made looking forward, not backward. A 10-year breakeven rate of inflation, for example, gives us the market’s best assessment of what the average annual inflation rate for the All-Urban CPI, not seasonally adjusted, will be.

Those assessments account for the various options embedded in the TIPS market, including what the tax rate will be on the accrual of the bonds’ principal and how the government chooses to report inflation (yes, you are short a call option on government honesty). More critically, some key financial variables such as currency rates and the shape of the yield curve are affected by expected, not reported, inflation.

The CNY began its managed revaluation in July 2005. The up move (green vertical line) accelerated in August 2006 while the TIPS breakeven inflation rates simultaneously turned lower. While the five- and 10-year breakeven rates rebounded somewhat between November 2006 and March 2007, the 30-year breakeven rate remains under pressure, and all three breakeven rates remain lower than they were in August.

If a stronger CNY is inflationary, it is certainly doing a good job of disguising itself in the data. Let’s repeat for emphasis: The rise of the CNY coincided with a decline, not an increase, in expected inflation. This is 180 degrees opposite to what the standard theory would predict.