Inflation's still not a risk but arguably neither is deflation. We're not quite ready to officially claim that the D risk has been vanquished, but we're close. As it turns out, we're not alone.
The bond market is increasingly inclined to turn the page on the fear that a deflationary spiral may threaten. But if the deflation risk is passing, as it seems to be, the change doesn't mean that inflation is back. There's no switch that turns one off and the other on as cleanly as flicking on a light.
The ebb and flow of the economy is a process, an evolution. What we're seeing now, or so it appears, is a transition from a heightened risk of deflation to the absence of that risk, which isn't to be confused with inflation. At least not yet. There's no law that says inflation must quickly follow deflation. But neither is there any force that prevents one from turning into the other. Much depends on what the central bank does; not today but next month, next year and beyond.
Inflation, when it does bite, tends to creep up on you, slowly, quietly, working its way into the economy virtually unseen. It doesn't suddenly arrive one day with fanfare and press releases. More typically, the crowd wakes up one day and realizes that inflation is back. The good news is that there are usually early warning signs. Interest rates, money supply, commodity prices, and so on. The challenge is figuring out in real time what constitutes a legitimate warning vs. noise.
For the moment, the market's telling us that deflation's a fading hazard. As the chart below shows, the implied inflation rate in the bond market (based on the yield spread between the nominal 10-year and inflation indexed Treasuries) was just under 2% as of last night's close. That's still comfortably below the 2.5% rate that prevailed before the financial system ran amuck starting last September. But it's also up sharply from the near-zero levels of December and January.
That's not necessarily surprising or even troublesome. Fearing the worst last fall, the Fed quickly dropped short rates to near zero. The medicine appears to be working, which is to say that Bernanke and company are engineering higher prices. But it's the momentum we fear. Not necessarily today, but down the road.
Some commentators say that all the talk of inflation is premature and perhaps misguided. In his column last week in The New York Times, Paul Krugman advises readers that "when it comes to inflation, the only thing we have to fear is inflation fear itself."
That's a reassuring thought, but unfortunately it runs contrary to the historical record. Maybe this time is different, but we don't know. But the past is certainly clear. Except for a few extraordinary examples to the contrary, inflation has been the norm. For the most part, it's been manageable, although sometimes it spins out of control, as it did in the 1970s and early 1980s. Recessions, of course, have a habit of pounding inflation back into the ground. Even after the current downturn ends, its after-effects are likely to put a lid on pricing pressures and so there's reason to be sanguine about future inflation threats.
The ever-trenchant Martin Wolf advises in his FT column today that there's no economic basis to fear inflation, at least not now. "The jump in bond rates is a desirable normalisation after a panic," he writes. "Investors rushed into the dollar and government bonds. Now they are rushing out again."
The question, of course, is when is it safe to start worrying about inflation? The implied inflation rate for the next 10 years is roughly 2%. That's low by historical standards and if it stayed there for the next generation the central bank could claim a well-deserved victory in maintaining price stability, at least by the standards of the 20th century.
But no one knows if inflation will rise to, say, 2% and stay there or keep climbing. Again, much depends on what the central banks do from here on out. One can make an economic case that exploding government debt and massive liquidity injections aren't destined to raise inflation pressures, as Wolf and others explain. That's a reasonable view, but if you're charged with protecting assets, such claims that all's well aren't entirely persuasive.
The bond market, along with the gold and forex markets, are discounting the future and all its risks and they're telling us that the risk of higher inflation is on the march. It's quite possible that the markets are wrong and so inflation will remain a shadow of its former self. Let's hope so. But there's no way of knowing for sure. Strategic-minded investors should hedge their bets. Inflation may remain benign, but it may not. The markets are struggling to put a price on this uncertainty.
In any case, it's the trend rather than the absolute levels that worry investors. Estimating the true rate of inflation is always a contentious subject. But while we can all argue over the numbers, the trend is less obscure, and it's the trend that has some of us worried. Taking out a bit of insurance, then, seems reasonable. Should we bet that house on higher inflation? Of course not. But neither should we discount it entirely. It may be different this time, but 300 years of central banking keeps us wary on buying into yet another argument that a new era has arrived.