By Rom Badilla, CFA
Since the Financial Crisis, many critics have blasted the Federal Reserve’s unconventional easing policies such as QE since it threatens future inflation. Inflationary expectations as measured by the spread between the 10-year Treasury yield and the comparable TIPS yield have increased recently. After the announcement of the latest round of QE, the spread jumped at a high of 2.64% on Sept. 14, matching the peak set in April 8, 2011, during QE2. As of Monday, inflation expectations have dipped back down a bit to an elevated level of 2.42%.
Having said this, actual inflation pressures have remained subdued in the U.S. In particular, U.S. Core Prices, which strips out food and energy, rose just 0.05% in August. This translates to a year-over-year increase of just 1.9%, which is the first print below two since mid-2011. In addition, inflation in other countries continues to tick lower despite central bank easing policies from around the globe.
JP Morgan’s economic research team of David Hensley, Joseph Lupton, and Michael Mulhall suggested that global inflation pressures will remain low for the time being. In their latest Daily Economic Briefing, the economics team wrote the following:
While our global CPI perked up nearly 0.4%m/m sa in August, the acceleration was entirely due to the effects of higher food and energy prices. Our measure of global core consumer prices, which strips out these more volatile categories, inched up just 0.09%m/m sa in August, the softest rise in six months. The year-ago rate of global core inflation ticked down to 1.9%, continuing the slow and steady downward drift since it peaked at 2.3% in late 2011. While the monthly sequential increase in headline consumer prices is likely to remain firm in September, the continued softness in core prices suggests negligible underlying inflationary pressure. With global GDP likely delivering its seventh consecutive quarter of at-or-below potential growth in 3Q12, high rates of resource slack are keeping core inflation muted.
It is hard to argue the growing yield differential between Treasury yields and TIPS since monetary economic theory suggests that an increase in the supply of money will result in rising prices assuming all else equal.
However, the fact is that historical inflation has remained benign during and after previous rounds of accommodative policies by central banks. In essence, experience reminds us that economic models fall apart when assumptions are broken. Specifically, as households, businesses, and governments continue to de-level and unwind their debt obligations, the propensity to spend remains low for quite some time. The Great Recession was not your typical economic recession so why should the recovery be a normal one? Hence in the context of economic theory, all else is far from equal. As a result, one has to wonder about the sustainability of the rise in inflation expectations and the mounting criticism of the Federal Reserve and central banks from around the world.
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