Dismissing Inflation as Yesteryear’s Worry is Asking for Trouble

The ascent in the yield on the 10-year Treasury Note during this past spring took a breather after rising to nearly 4.0% by mid-June. That prompted some to claim that the underlying source for the rise—worries about future inflation—were overbaked.

Perhaps, but we beg to differ, and have for some time. Even when the crisis of last fall was exploding with all its ignominious power, we were of a mind to expect a return of inflation at some point. The CPI report last week suggests that such expectations are still valid.

To be sure, the risk an imminent surge in inflation to lofty levels still looks low. Although deflationary forces are fading, the blowback from the financial crisis and the lingering effects of the current recession will reverberate for some time and so pricing pressures are still muted. Nonetheless, it’s always been clear that the Federal Reserve’s primary goal was to return the system to an inflationary bias. A mild one, if possible, but inflationary just the same. We never doubted the Fed’s capacity for success on that front, and neither it seems does the bond market. The question is whether the central bank can let the genie out of the bottle just a little?

The genie already has his nose out. One example comes by way of the outlook for inflation based on the yield spread between the nominal and inflation-indexed varieties of the 10-year Treasury Notes. As our chart below shows, the market’s 10-year inflation forecast is creeping up, again. Yes, it’s still quite low—under 2.0%. But it’s the directional momentum that’s the issue. Having elevated the market’s inflation expectations from zero to roughly 2% in the last six months, the Fed must soon begin to pull back on the liquidity injections, if only just slightly. Raising Fed funds to 0.5% would be reasonable at some point in the near future, up from the 0-0.25% range that currently prevails, if only to send a signal to the markets about intent.

One reason the message needs to be made is that traders don’t think that’s likely any time soon, based on Fed fund futures. The September 2009 contract, for instance, is trading at an implied 0.2% Fed funds rate.

A fair chunk of keeping inflationary pressures under wrap is a task of managing expectations, through time. There’s currently no danger that expectations are set to run amuck, but neither can we afford to ignore the creeping rise in inflation expectations, even at low levels. Perhaps it’s a false alarm, perhaps not. We just don’t know. Waiting for definitive confirmation is too risky. Hedging the bet by slowly moving rates up over time–short of more compelling data to do something else–seems reasonable.

The future is undoubtedly full of surprises. But this much is clear: dismissing inflation as yesteryear’s worry is asking for trouble.

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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