Market Evaluation of Inflationary Expectations and Credit Risks

by: John M. Mason

With all that has been happening in the financial markets over the past six months or so, it is worthwhile to check in from time-to-time to see what is happening to market expectations of inflationary expectations and credit risk. During this time the Federal Reserve has substantially lowered its target for the Federal Funds rate and has provided liquidity to the banking system in order to contain a liquidity crisis in world financial markets and perhaps to lessen the magnitude of any economic slowdown that might be forthcoming.

The growth of aggregate monetary and reserve statistics has remained steady. The narrow measure of the money stock (M1) continues to decline by about 0.5% year-over-year and the broader measure (M2) continues to rise at about 6.0% year-over-year. Total reserves in the banking system also continue to decline through January, 2008 at a 0.9% rate, year-over-year. This latter decline reflects the outflow of funds from transactions accounts (reflected in the decline in the narrow measure of the money stock) into time and savings accounts (that are still within the definition of the broader measure of the money stock). So, not much has changed even with all the other things going on in the financial markets.

In terms of expected inflation, little has changed over this time period. The measurement I am using is the difference between the rate on 10-yer US Treasury constant maturity bonds and the rate on 10-year inflation indexed bonds. In August, 2007, inflationary expectations were approximately 225 basis points and toward the middle of February, 2008, inflationary expectations were approximately 230 basis points. The average over this time period was roughly 230 basis points. Thus, even though the Federal Reserve has, arguably, loosened up, the market has not translated the Feds actions as worsening the possibility that inflation will rise in the foreseeable future.

There has been a shift in attitudes toward credit risk over this time period. In August and September 2007 the difference between Moody’s Baa and Aaa bond yields averaged around 85 basis points. In November 2007 this spread started to rise and reached about 120 basis points in January 2008. In the middle of February 2008, the difference has averaged around 130 basis points. Market participants have become more concerned with credit risk over the past six months and this attitude has been built into current yield spreads.

Conclusions: Market participants are not concerned that the recent actions of the Federal Reserve will have much long term impact on the rate of inflation; however, they are increasingly concerned about the credit crisis and the solvency issue.