Inflation expectations have risen sharply in the past few weeks and are now at pre-crisis levels.
The economy, meanwhile, is sputtering along, and unemployment remains at 10%.
Taken together, these inconvenient truths create a major bind for the Federal Reserve: Raise rates to curtail inflation, and you'll infuriate everyone who cares about the economy (most of us). Let inflation run wild, and you'll screw anyone who has ever saved anything.
One bit of good news: Asha Bangalore at Northern Trust thinks the weak economy (and high unemployment) will keep a lid on inflation for a while. So perhaps the Fed can continue to have it both ways.
Inflation expectations as measured by the difference between yields of the nominal U.S. 10-year Treasury note and the 10-year inflation protected security are now at levels seen prior to the onset of the financial crisis in August 2007 (see chart 1). As of January 8, the difference between the nominal yield and yield on the inflation protected 10-year U.S. Treasury securities was 242 bps. Inflation expectations have climbed 28 bps during the last 20 trading days...
Bullish economic reports are most likely to lead to pressure on long-term interest rates and push inflation expectations into a new range. Having said that, a caveat is necessary, final demand in the U.S. economy is significantly weak and it is unlikely to post robust growth until the final three months of the year. Therefore, it is reasonable to expect that inflation expectations will remain anchored in the months ahead.
Disclosure: No positions