Inflation isn’t a concern these days, affording the Federal Reserve elbow room to keep interest rates at, well, virtually zero.
The futures market doesn’t expect the free-money train to end any time soon. Even looking a year out, Fed funds futures are still pricing the central bank’s target rate at under 1%. The FOMC hasn’t done anything to disabuse the crowd from that view. Last month’s official monetary confab press release advised that “the Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent…for an extended period.”
One of the reasons that the Fed can keep the monetary pumps primed in excess is that the velocity of money (a measure of the frequency that money is spent) is quite low, as a recent reading via the St. Louis Fed shows. (Velocity is calculated as nominal GDP divided by some measure of money supply.) In some schools of economic thought—notably those who ascribe to the quantity theory of money—a rising velocity is a harbinger of future inflation. By this standard, the muted change in velocity suggests that the risk of higher inflation remains relatively low, enabling the central bank to print money to a degree that would otherwise raise alarm about future pricing pressure.
But while the threat of imminent inflation is minimal, the market is slowly but consistently rethinking the wisdom of giving away money. Indeed, as our chart below illustrates, the Treasury market’s 10-year inflation forecast has just about returned to the levels that preceded the great debacle on Wall Street in the fall of 2008.
The implied inflation outlook, based on the spread between the nominal and inflation-indexed 10-year Treasuries, reached 2.38%, as of January 11, 2010. That’s nearly the level the prevailed before all hell broke loose in September 2008. Having returned to a “normal” inflation outlook, the question is, Now what? We’ve come full circle. But while the inflation outlook is back where it started, almost everything else has changed.
The leading difference is that the Fed’s expansionary monetary policy is on steroids, which stands in contrast to the last time that Treasury based inflation forecast was roughly 2.5%. This isn’t particularly worrisome to some economists, including Asha Bangalore of Northern Trust. One explanation for why there’s no immediate cause for concern is that banks aren’t lending, which is keeping a lid on inflationary pressures.
So far, so good. But strategic-minded investing is as much about looking forward as it is assessing what’s known in the here and now. With that in mind, the operative question: Would you tie up a significant chunk of money in a nominal 10-year Treasury today? It’s tempting to answer “yes,” based on a stellar trailing returns in bonds over the past year or so and the comforting news that inflation isn’t an obvious threat. Alas, rear view mirrors only get you so far in finance, and sometimes (if you’re not careful) they can throw you in the ditch.
To be fair, we agree that the inflation threat is likely to stay muted for the foreseeable future, for the reasons cited above along with other factors. The real danger is assuming that today’s truth will remain tomorrow’s wisdom as well. But for now, the risks of printing money remain low. Each day, however, the risks rise. At some point, the frog will jump out of the pot. That’s virtually assured. As always, timing is an open question.