What do you think the inflation rate will average in the United States over the next 5 years?

Before you answer that question, here is some additional information to consider. During the peak of the financial crisis back in late 2008, investors were predicting that prices would decline by a small fraction of 1% for 10 years, i.e., we would have 10 years of deflation, according to a January 29, 2009 Bloomberg article.

To determine what investors expect inflation to average in the future, we simply calculate the difference in yield between Treasury Inflation Protected Securities (TIPS) and a similar maturity U.S. Treasury security. For example, if the yield on a 10-year Treasury was 2.6% and the yield on a 10-year TIPS was 0.6%, then that suggests investors expect inflation to average 2.0% over the next 10 years. This difference of 2.0% is called the "breakeven rate."

Unlike a regular Treasury security, the principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, investors are paid the adjusted principal or original principal, whichever is greater, according to the Treasury Department. Hence, TIPS are considered a hedge against inflation, according to The Wall Street Journal.

Okay, do you have your 5-year inflation rate guess now? Unlike late 2008, investors now expect inflation to average 1.59% over the next 5 years, according to an October 25 Wall Street Journal article. For historical reference, inflation has averaged 3.0% per annum compounded annually from the beginning of 1926 to the end of 2008. On a 5-year basis, it averaged a high of 10.1% per annum compounded annually for the 5 years ending December 31, 1981 according to the Ibbotson SBBI 2009 Classic Yearbook.

By historical standards, the expected 5-year inflation rate of 1.59% is low. However, the Federal Reserve is doing what it can to stoke inflation in an attempt to prevent deflation and as a way to pay down our federal debt using "cheaper" dollars.

Notes: S&P 500, DJ Global ex US, Gold, DJ-UBS Commodity Index returns exclude reinvested dividends (gold does not pay a dividend) and the three-, five-, and 10-year returns are annualized; the DJ Equity All REIT TR Index does include reinvested dividends and the three-, five-, and 10-year returns are annualized; and the 10-year Treasury Note is simply the yield at the close of the day on each of the historical time periods.

Sources: Yahoo! Finance, Barron's, djindexes.com, London Bullion Market Association.

Past performance is no guarantee of future results.  Indices are unmanaged and cannot be invested into directly.  N/A means not applicable or not available.