Expected Inflation Continues to Fall

It’s still happening. Eight months on and counting, expected inflation continues to fall at a steady pace as seen below:

Several things to note about this remarkable downward trend.

First, given that productivity is now declining this picture screams out that total current dollar spending is expected to decline. That is, the market expects weaker aggregate demand (AD) in the future and, as a result, there will be lower inflation. Even if one is convinced that this downward trend is being driven in part by a heightened liquidity premium the implication is the same. A heightened liquidity premium indicates increased demand for highly liquid assets like treasuries and money which, in turn, imply less aggregate spending. Recent AD forecasts support this interpretation.

Second, the spread has on averaged declined about 0.55 basis points a day over the January 4, 2010 – September 2, 2010 period. At this pace and with no policy change, zero inflation expectations will be hit sometime around March 2011. Thereafter, it’s a deflation expectation world.

Third, the Fed has done nothing meaningful to arrest this downward trend. The biggest move it made was on August 10 when it announced plans to stabilize the size of its balance sheet. The spread continued to fall after the announcement. The failure of the Fed to stabilize this downward trend amounts to the Fed passively tightening monetary policy. Lest you think I am being too critical here, Bernanke admitted in his Jackson Hole speech that Fed was passively tightening by not stabilizing the Fed’s balances sheet. By his own logic then, the Fed is tightening by allowing inflation expectations to deteriorate.

Finally, this is the longest-running decline for this spread since the daily TIPS data for this maturity became available in 2003. Yes, the 2008 decline is larger, but it only lasts from July to November, 5 months. This decline is going on 8 months now with no end in sight. If the Fed continues to ignore this downward trend one can only imagine how ingrained these expectations will become.