Analytically, there are three components to an interest rate. The first is the risk that the money will not be paid back. This is a very big factor when dealing with corporate bonds, especially junk bonds. For the U.S. government's obligations, as the owner of a nice shiny printing press that can always be turned on to pay back any obligation denominated in dollars, that part is assumed to be zero.
The second part is expected inflation. After all, if you decide that you want to consume something later, rather than today, and thus decide to save and invest your money, you want to be sure the dollar you put away today buys at least as much in, say, ten years that it does today. If you expect that it will buy less bread, gasoline and clothing in ten years, then you would demand a higher interest rate to offset the diminution in purchasing power.
Finally, most people would rather enjoy themselves today rather than put off that enjoyment until some time in the future. As a result they demand a real interest rate, over and above the rate of inflation, to reward them for their delayed gratification, even if there is no risk that they will not be paid back.
Since 2003, the government has been selling bonds where the amount of the principal that gets paid back when the bond matures rises with the rate of inflation over the life of the bond, called TIPS. Aside from the fact that it is a much smaller and illiquid market than that of regular T-notes, TIPS make a great vehicle for tracking the real rate of interest that investors want in return for consuming later, rather than today.
Well, if repayment risk is assumed to be zero, and we know what the real rate is, then the difference between a regular T-note and the TIPS of the same maturity is what the market expects inflation to be over the life of the bonds. The yield on regular 10-year T-notes is shown in blue in the graph below, while the rate on 10-year TIPS is in pink, and the difference is shown in yellow.
Since TIPS were introduced, the average difference has been 2.17%.? As of last week, the difference was 2.12%. In other words, the market does not expect inflation to be more of a problem over the next ten years than it has feared about inflation since 2003.
Aside from the price of oil and some other commodities, the last six or seven years have not been a particularly high inflation time (well, they have been for Health Care and Education, too, but overall inflation has been pretty well contained).
