Inflationary Perfection: Too Good to Be True?

The Treasury market's inflation forecast has remained fairly steady since May, hovering in the 1.5% to 2.0% range. As of Monday's close, the current outlook for inflation is 1.80%, based on the yield spread between the nominal 10-year Treasury less its inflation-indexed counterpart.

As our chart below shows, this stability follows a period of extreme volatility, launched last September when the implosion of Lehman Brothers sparked a steep wave of selling in almost everything, government bonds being the leading exception.

The Treasury market's 1.8% inflation outlook contrasts with the most-recent 12-month change in the headline consumer price index, which dropped 1.5% for the year through August. But if we look at core CPI, which excludes the volatile energy and food sectors, prices rose by 1.4% for the 12 months through last month. That's just under the 1.8% inflation forecast implied by the Treasury market.

If future inflation for the next decade lives up to the current forecast, the pace of consumer price changes will compare well with the historical record. A world where inflation resides under 2% is favorable if we use the long-run past for comparison. But inflation expectations, nor inflation itself, is a constant, and therein lies the potential for mischief making.

Such concerns will no doubt be on the agenda of the Fed's FOMC meeting, which begins today and concludes tomorrow. For the moment, however, the market expects that the central bank will keep monetary policy on an even keel, which is to say maintaining its Fed funds interest rate target of 0-0.25%.

As our second chart below illustrates, Fed funds futures project rates will stay unchanged for the next few months, rising slowly in 2010. If the futures market is correct, a year from now we'll see Fed funds at roughly 1.0%.

It all makes for a wonderful outlook. Inflation is low and expected to stay that way, save for a s-l-o-w rise in the months ahead from an extremely low base. As inflation projections go, this is about as good as it gets. And that's what worries us.

But for now, all's well. Enjoy it while it lasts.

Comments

[Nathaniel C:]

The bond market has a terrible track record of prediciting inflation. In 2007 and early 2008 the bond market never thought inflation was over 3%. Talk about out of touch with reality!! I have little faith that the bond market will be correct with inflation under 2% for the next ten years. I think this idea comes from the Keynesian idea that it is impossible to have inflation with low aggregate demand, high unemployment, and weak capacity utilization.

Marc Faber commented that you do not have to have a booming economy to have inflation. Look at Zimbabwe. The facts are that the FED has printed trillions of dollars along with central banks around the world. If this does not lead to inflation then we have truly entered a new era of magical prosperity where you can print trillions and everyone is happy. History shows otherwise.

Sep 22 07:12 PM

[Homer II:]

What do you call it when hard commodities all rise 40%, 50%, 80% over the last 3-4 months? Speculation? Don't believe me? Look at 3 month charts of any mining tissues of gold, silver, platinum, oil, copper, aluminum.
The "they" bureau are saying, "it's not inflation; it is the declining dollar". If it looks like inflation, feels like inflation, walks like inflation, why I'd expect that's what it is.

Sep 23 02:52 AM

[Mad Hedge F...:]

ujn ) I spent the evening with David Wessel, the Wall Street Journal economics editor, who has just published In Fed We Trust: Ben Bernanke’s War on the Great Panic. I doubted David could tell me anything more about the former Princeton professor I didn’t already know. I couldn’t have been more wrong. Bernanke was the smartest kid in rural Dillon, South Carolina, who, through a series of improbable accidents, ended up at Harvard. He built his career on studying the Great Depression, then the closest thing to paleontology economics had to offer, a field focused so distantly in the past that it was irrelevant. Bernanke took over the Fed when Greenspan was considered a rock star, inhaling his libertarian, free market, Ayn Rand inspired philosophy. Within a year the landscape was suddenly overrun with T-Rex’s and Brontesauri. He tried to stop the panic 150 different ways, 125 of which were terrible ideas, the remaining 25 saving us from the Great Depression II. This is why unemployment is now only 9.8%, instead of 25%. The Fed governor is naturally a very shy and withdrawing person, and would have been quite happy limiting his political career to the local school board. But to rebuild confidence, he took his campaign to the masses, attending town hall meetings and meeting the public like a campaigning first term congressman. The price of his success has been large, with the Fed balance sheet exploding from $800 million to $2 trillion, solely on his signature. The true cost of the financial crisis won’t be known for a decade. The biggest risk now that having pulled back from the brink, we will grow complacent, and let needed reforms of the system slide. How Bernanke unwinds this bubble will define his legacy. Too soon, and we go back into a depression. Too late, and hyperinflation hits. Let’s see how smart Bernanke really is.

Sep 23 09:49 PM