How should one price breakeven inflation?
Theory has it that one should price 10-yr breakeven inflation with 10-yr ahead expected inflation. This is logical, but is it right? I argue in numerous places - that no - this is wrong. All it ends up doing is allowing us to ascribe a residual on a liquidity risk premium rather than an inflation risk premium. So what should we do?
I propose we remove the long-term inflation expectations and swap it out for the ISM price index. The ism price index IS a measure of expected inflation and change in expected inflation - in other words it contains both the expected inflation and inflation risk premium. And the transformation required is simple: [(ISMPI - 50)/50] + 2. That's it! So simple. It looks like a structural change occured in 2016 so my simple adjustment would produce a consistently lower inflation risk premium. This can be fixed with a step indicator.
I propose we remove the long-term inflation expectations and swap it out for the ISM price index. The ism price index IS a measure of expected inflation and change in expected inflation - in other words it contains both the expected inflation and inflation risk premium. And the transformation required is simple: [(ISMPI - 50)/50] + 2. That's it! So simple. It looks like a structural change occured in 2016 so my simple adjustment would produce a consistently lower inflation risk premium. This can be fixed with a step indicator.