The Federal Reserve yesterday talked about fighting inflation by raising rates, but so far it's only talk. But while the central bank chatters, inflation expectations continue creeping higher.
Consider the yield spread between the conventional 10-year Treasury and its inflation-indexed counterpart, a.k.a., the 10-year TIPS. The difference between the two yields is a widely followed market-based outlook on future inflation. By that standard, the market anticipates inflation at 2.5%, as of last night's closing yields. As you can see from our chart below, that's up modestly from last August's 2.2% outlook.
To be sure, the rise isn't dramatic. What's more, the inflation expectation of late is still middling compared with recent years. But it's the trend that worries us. Although no one knows the future, the fact that the market's inflation expectations are rising, albeit marginally so far, reminds that pricing pressures are bubbling and it's starting to have an effect on investor sentiment.
But before any one gets too comfortable with the numbers, keep in mind that the 2.5% market-based outlook for inflation is well below the consumer price index's current annual rise of 4.2%, as of May.
Such news may be worrisome to some observers, but the Fed is still expecting salvation to arrive soon and rescue the central bank from the dirty work of hiking rates. As the Fed announced in yesterday's FOMC statement, it "expects inflation to moderate later this year and next year."
The question is whether the markets will jump on that bandwagon? There's still time to debate both sides, but the clock is ticking and resolution, one way or the other, is coming. Much depends on food and energy prices, of course, which are the poster children for the inflation troubles of late. In short, tell us where energy and food prices are headed and we'll tell you how the inflation soap opera ends. Alas, the story still unfolds one day at a time. Meantime, this is no time to bet the house on one outcome or the other. Hedging one's bets seems more than reasonable these days.