Is This the Start of an Inflationary Surge?

The “Bond Market Flashes Inflation Warning,” advises The Wall Street Journal. CNBC reports that “Investors Starting to Believe That Inflation Threat is Real.” Is this the start of an inflationary surge? Maybe, although there’s still room for debate.

One of the reported warning signs is the rise in long-term interest rates. The benchmark 10-year Treasury yield is approaching 3.7%, up from as low as 2.5% last fall. But the current yield is still below the 4% mark reached last April. The implication: the rise in yield reflects the waning disinflation/deflationary worries that plagued sentiment last summer/fall. The Fed’s second round of reflationary policies announced last November were intent on delivering no less. Surely it would be far worse if yields remained low and/or falling. The fact that higher yields have also accompanied signs of modest economic revival–such as the recent improvement in commercial lending and the ongoing gains in consumer spending and income–suggest that the inflation fears may be overdone, at least for the moment.

Another concern is that the yield curve is steepening. The spread between 10-year and the 2-year Treasuries, for instance, is around 2.9 percentage points, the widest in nearly a year. But this too still looks like a shift from the deflationary worries that prevailed last summer and fall, when the 10-year/2-year spread dropped to 2.0 percentage points.

There’s also concern that rising commodity prices signal future inflation. Prices of raw materials are in fact rising. The iPath DJ-UBS Commodity ETN (DJP), which tracks a broad definition of commodities, is up 28% over the past year through February 7.

Commodities prices have been known to bring an early warning sign about mounting inflation risks, but not always. Commodities are quite volatile as a general rule, and so today’s price increases may bring tomorrow’s sharp declines. That’s why economists monitor inflation with and without commodities (i.e., core inflation). Over time, the so-called core measures of inflation have proven to be superior indicators of the broad pricing trend.

For example, comparing the rolling 12-month percentage changes in headline and core inflation benchmarks for the U.S. shows that core CPI remains subdued (red line in chart below). Headline CPI, by contrast, is turning up (blue line). Keep in mind, however, that headline inflation is quite volatile and in recent years it’s proven to be a misleading gauge. In 2008, for instance, headline CPI was soaring, even though inflationary pressures were set to collapse.

The trick, as always, is deciding if rising commodities prices is a trend with legs as opposed to the boom-bust cycle that usually prevails for the asset class. Some analysts argue that the risk of persistent price gains is quite real, in part because emerging nations like China and India are consuming ever-larger quantities of energy and other commodities. In a world of finite resources, surging demand threatens to unleash a secular bull market for oil, food, and other materials, which in turn raises the inflation danger.

Perhaps, although for the moment the crowd is on the fence. The market’s inflation forecast is a modst 2.4%, based on the conventional 10-year Treasury yield less its inflation-indexed counterpart. That’s up sharply from 1.5% last August, when worries of deflation were high, but inflation expectations in the mid-2% range doesn’t look excessive relative to history.

The question is whether inflation expectations have merely rebounded now that the economic outlook has improved? Or is there something more ominous approaching? It’s an open debate. But with the labor market still weak, the case for seeing inflation rising looks thin. Of course, all bets are off if job creation moves into a stronger phase. What if employment growth remains weak? The possibility of stagflation—rising inflation and weak growth—lurks too, some analysts say.

The other crucial variable is how the Federal Reserve manages its exit strategy for unwinding its monetary policy. The worry here is that the central bank, run by human beings, is subject to error. Given the history of the Fed, this may be the leading reason for worrying about future inflation.

About James Picerno 894 Articles

James Picerno is a financial journalist who has been writing about finance and investment theory for more than twenty years. He writes for trade magazines read by financial professionals and financial advisers.

Over the years, he’s written for the Wall Street Journal, Barron’s, Bloomberg, Dow Jones, Reuters.

Visit: The Capital Spectator

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