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September 4, 2015

5-Year Deflation Probability Moves Off Zero

Since 2010, our Bank has regularly posted 5-year deflation probabilities derived from prices of Treasury Inflation-Protected Securities (TIPS) on our Deflation Probabilities web page. Each deflation probability, which measures the likelihood of a decline in the Consumer Price Index over a fixed five-year window, is estimated by comparing the price of a recently issued 5-year TIPS with a 10-year TIPS issued about five years earlier. Because the 5-year TIPS has more "deflation protection" than the 10-year TIPS, the implied deflation probability rises when the 5-year TIPS becomes more valuable relative to the 10-year TIPS. (See this macroblog post for a more detailed explanation, or this appendix with the mathematical details.)

From early September 2013 to the first week of August 2015, the five-year deflation probability estimated with the most recently issued 5-year TIPS was identically 0 as the chart shows.


Of course, we should not interpret this long period of zero probability of deflation too literally. It could easily be the case that the "true" deflation probability was slightly above zero but that confounding factors—such as differences in the coupon rates, maturity dates, or liquidity of the TIPS issues—prevented the model from detecting it.

Since August 11, however, the deflation probability has had its own "liftoff" of sorts, fluctuating between 0.0 and 1.3 percent over the 16-day period ending August 26 before rising steadily to 4.1 percent on September 2. Of course, this rise off zero could be temporary, as it proved to be in the summer of 2013.

How seriously should we take this recent liftoff? We can look at options prices on Consumer Price Index inflation (inflation caps and floors) to get a full probability distribution for future inflation; see this published article by economists Yuriy Kitsul and Jonathan Wright or a nontechnical summary in this New York Times article. An alternative is simply to ask professional forecasters for their subjective probabilities of inflation falling within various ranges like "1.0 to 1.4 percent," "1.5 to 1.9 percent," and so forth. The Philly Fed's Survey of Professional Forecasters does just this, with the chart below showing probabilities of low inflation for the Consumer Price Index excluding food and energy (core CPI) from each of the August surveys since 2007.


Although the price index, and the horizon for the inflation outcome, differs from the TIPS-based deflation probability, we see that the shape of the curves is broadly similar to the one shown in the first chart. In the most recent survey, the probability that next year's core CPI inflation rate will be low was small and not particularly elevated relative to recent history. However, the deadline date for this survey was August 11, before liftoff in either the TIPS-based deflation probability or the recent volatility in global financial markets. So stay tuned.

Photo of Pat Higgins
By Pat Higgins, senior economist in the Atlanta Fed's research department