The TIPS bond market expects inflation of 2.1% over the next 10 years

As inflation approaches the Federal Reserve's 2% target, investors and corporate managers will look to market-based measures of inflation expectations to guide their decisions.

One of the measures used in such decisions is Treasury Inflation-Protected Securities (TIPS).

TIPS bonds were launched in 1997 and are relatively new securities. The value of the bond and its dividends are adjusted for the rate of inflation, with the value of the bond never falling below its original price.

For private and commercial investors, the TIPS market offers a guaranteed return, regardless of the impact of inflation.

In terms of the investment decision-making process, the implied breakeven inflation rate of TIPS yields has proven to be a reliable indicator of inflation expectations, with the TIPS yield providing a market-oriented estimate of inflation-adjusted real interest rates.

The current low level of real yields suggests that companies and governments will continue to invest in infrastructure and productivity, which will help reduce inflation.

The 10-year TIPS market is expecting inflation to fall to a reasonable level, averaging just under 2.1% over the life of the 10-year bond. That would be just above the Federal Reserve's inflation target of 2.0%.

The forward-looking TIPS data, as well as the real-time data, should give the Federal Reserve the confidence to make the long-awaited move to lower interest rates at its September meeting. We expect the Fed to cut its benchmark interest rate by 25 basis points.

This decline in inflation expectations comes as the personal consumption expenditures index, the Fed's preferred inflation measure, was 2.5 percent in July and the more popular consumer price index fell to 2.9 percent this month, below its 12-month average of 3.3 percent.

The yield on the 10-year Treasury bond is currently at 3.9 percent, a full percentage point below its recent high of 4.9 percent 10 months ago.

The 10-year TIPS bond, which is an approximation of the real yield, yields 1.8 percent, 0.7 percentage points below its recent high of 2.5 percent.

For companies with an investment horizon of five years, the TIPS yield is 1.8 percent with an expected inflation rate of just under 2 percent.

The 3.9% yield on government bonds can be broken down into the real yield of 1.8% on the TIPS market plus the expected inflation rate of 2.1%.

Read more RSM insights on inflation, the economy and the middle market.

The recent decline in yields on US Treasury bonds and TIPS bonds underscores the success of the US Federal Reserve's campaign to squeeze inflation out of the economy.

In general, we would expect the bond market to anticipate the Fed's decisions to cut its benchmark interest rate and push down interest rates on all securities except Treasuries and the shortest-dated bonds, which are directly tied to the federal funds rate.

We expect the Fed to cut its benchmark interest rate to the new post-pandemic neutral range of 3-3.5 percent over the next year. If that happens, we would expect a downward rebalancing of the entire Treasury curve, with rates falling more sharply at the bottom of the curve between two and five years than at the longer end, leading to a normalization of the Treasury curve.

Market prices as of August 19 suggest that the interest rate on two-year bonds will be 3.54 percent and that on ten-year bonds will be 3.89 percent at the end of next year.