The Swaps Strike Back: Evaluating Expectations of One-Year Inflation

Abstract

This study examines the forecasting performance of inflation swaps and survey-based expectations for one-year inflation. Conducting this exercise helps determine if one set of expectations can provide a cleaner signal about future inflation. The study finds that, overall, inflation swaps more frequently provide better forecasts of future inflation. Previous studies that found poor performance of swaps were strongly influenced by liquidity issues during the financial crisis and the pandemic. When these periods are excluded, swaps have superior predictive ability. Our analysis suggests that combining the two expectations can lead to even better forecasts. The optimal static combination is roughly an equal weighting of swaps and surveys. Alternatively, a dynamic smooth-transition regime switching model can also lead to superior performance and provide a clearer signal on expectations of future inflation. Recently, this measure has implied the Federal Reserve is expected to be closer to its inflation target over the next year than the surveys would suggest.

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