. 5 a separate issue that bears on the relevance of breakeven inflation for policymaking is that tips returns depend on the overall consumer price index ( cpi ), whereas for many purposes policymakers are more interested in the behavior of core inflation, a measure of inflation that strips out volatile food and energy prices. in fact, tips returns appear sensitive to fluctuations in oil prices. as a partial fix of this problem, the breakeven inflation rates shown in figure 1 are calculated by comparing the yields of tips and so - called off - the - run securities. within a given class of securities, say treasury bonds with ten years until maturity, off - the - run securities are securities other than those most recently issued. because off - the - run securities are less liquid than newly issued ( on - the - run ) securities, they provide a more appropriate benchmark against which to compare the yields of relatively illiquid inflation - indexed bonds. as sack ( 2000 ) has pointed out, this difference in duration implies that the breakeven inflation rate may be sensitive to the expected profile of future short real rates or be affected by differences in risk premiums arising from different exposure to interest - rate risk. sack addressed the issue of differing durations of nominal securities and tips by comparing yields on tips to yields on artificial securities constructed to provide the same pattern of real payments as a tips security, thereby eliminating the differences in duration noted in the text. he found, however, that the duration mismatch is less important quantitatively than differences in liquidity between on - the - run nominal securities and tips. a number of technical issues, such as the lags in the inflation adjustment procedure, affect the relationship of breakeven inflation and expected inflation. one such potential complication arises if the tax rates applicable to the marginal tips investor and to the marginal holder of nominal government securities are not the same, in which case the equilibrium breakeven inflation level will be affected. roll ( 2004 ) discusses the effects of taxation on the breakeven inflation rate. as you can see in figure 1, breakeven inflation rates have proven surprisingly volatile over their short history. for example, when nominal treasury yields swung sharply during the spring and summer of 2003, ten - year breakeven inflation moved sharply as well, declining about 40 basis points as the bond market rallied, then rising about 80 basis points when nominal yields came back up ( top panel ). this effect was seen also in inflation compensation at the five

- to - ten - year horizon ( bottom panel ), a rather counterintuitive result. what should we make of the volatility of breakeven inflation over recent years? one interpretation is that inflation expectations are not as well anchored as policymakers would like ( see bernanke, 2004, for additional evidence on this point ). the fact that inflation compensation tends to react strongly both to releases of macroeconomic data and to unexpected changes in monetary policy ( gurkaynak, sack, and swanson, 2003 ) supports this interpretation. still, at this point i think we need to be cautious about drawing strong conclusions about the short - run behavior of expected inflation from the data on breakeven inflation. the fact that the volatility of breakeven inflation is so much greater than that of standard survey measures of inflation expectations ( such as those collected by the federal reserve bank of philadelphia for professional forecasters or by the university of michigan for consumers ) should give us pause. the responsiveness of breakeven inflation to what might be construed primarily as liquidity disturbances, such as the russian debt crisis and recent bouts of mortgage hedging activity that roiled treasury markets, suggests that variable liquidity premiums, together with varying inflation risk premiums, contaminate breakeven inflation as a measure of expected inflation. 6 i have emphasized some reasons to be cautious in interpreting breakeven inflation as expected inflation. nevertheless, i expect that the usefulness of inflation - indexed securities as a tool for measuring expected inflation will increase over time. the liquidity of tips should continue to improve as the share of government debt issued in inflation - linked form continues to rise, particularly if the treasury decides to expand the range of maturities of indexed bonds that it offers. moreover, as i will discuss briefly later in the talk, our ability to model risk and liquidity premiums is improving, which will help us control for an important source of volatility in breakeven inflation. finally, the universe of inflation - linked financial assets seems to be increasing, which will allow for fruitful comparisons and cross - checking. for example, futures on the cpi were recently introduced on the chicago mercantile exchange. although these contracts are not yet widely traded, they may at some point provide useful measures of breakeven inflation out to the maturity of the shortest - term tips, thereby filling in an important portion of the term structure of breakeven inflation. interest rates and spreads