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What's the outlook for inflation?

The question is simple enough. But the answer is complicated these days. In fact, there's an array of inflation expectations to pick from in the summer of 2008. If you're looking to commodity prices as an early warning sign of future pricing trends, the message has been clear: inflation will rise in the months and years ahead.

Skeptical? Perhaps the recent updates on consumer and wholesale price inflation will change your mind. As we noted yesterday, the trend in producer prices has been unmistakably up. Meanwhile, consumer price inflation shows similar symptoms.

Expecting inflation to continue bubbling, in other words, seems like a reasonable proposition. Or so recent history suggests. But such thinking finds no favor in the Treasury market. The prospect of higher inflation is a bond investor's worst nightmare, but you'd never know it by looking at the CPI-adjusted yield on the nominal 10-year Treasury. Buyers of the 10 year apparently have no fear of buying a fixed-rate bond at a yield that, after adjusting for consumer price inflation for the past year, looks somewhat unappetizing.

As our chart below shows, the 10-year Treasury yield less annualized consumer price inflation has been sinking into negative territory for some time. As of July, the 10-year Treasury's CPI-adjusted yield was negative 1.59%, based on using the monthly 10-Year Treasury constant maturity yield and subtracting the 12-month change in CPI, with data courtesy of the St. Louis Fed.

Suffice to say, it's been a while since the 10-year offered so little inflation-adjusted yield compensation. Not since the early 1980s has the prospect of owning a government bond looked so grim as an income producing security once inflation is considered. We can debate what it means, and whether it's even relevant for assessing the future of inflation. Nonetheless, the graph above is worth a close look before one dives headfirst into Treasuries at this point.

Or is it? The inflation-indexed Treasury market, a.k.a., the TIPS market tells us that the outlook for inflation is hardly frightening. As the second chart below suggests, the TIPS market is predicting consumer price inflation will run at less than 2.2%, or far below the 5.6% annual pace of CPI reported for July. (The TIPS inflation forecast is calculated as the spread between the nominal 10-year Treasury and its inflation-indexed counterpart.) This is the lowest inflation outlook in years from the TIPS market.

Clearly, something's amiss in the world of inflation forecasting. Maybe. Deciding where the error lies in real time is a challenge, of course. But that doesn't keep us from guessing. For our money, we doubt that headline consumer prices over the next 10 years will stay tame in the low-2% range. Call us crazy, but expecting something higher looks prudent.

Obviously, not everyone agrees. The glitch is that some believe the risk of recession, deflation and general turmoil in the economy overall will keep pricing pressures low in the years ahead. Investors have run for cover on the assumption that more trouble lies ahead, and the cover includes buying Treasuries, in both nominal and inflation-indexed forms. The higher demand has, of course, pushed yields down. And with the world more inclined to worry about deflation/disinflation, fear of inflation has been virtually dismissed. For the moment, anyway.

Alas, we don't know which forecast is right, but we do know that betting the farm on 2% consumer price inflation through 2018 doesn't look all that attractive as an investment proposition. Even in a world where credit crunches and debt reduction looks likely, one has to expect an especially dire scenario to think that inflation will all but evaporate in the years ahead. Yes, anything's possible, but not everything's probable.

Source: The Great Inflation Debate