The Federal Reserve has been trying to juice inflation higher for some time, and it appears that it’s had slight if precarious success over the past month. The market, at least, is pricing in slightly higher inflation for the decade ahead, based on the yield spread between the nominal and inflation-indexed 10-year Treasuries. As of yesterday, this inflation forecast was 1.78%, up a bit from 1.52% at the close of August, when worries of deflation were raging.
Inflation expectations have been creeping higher recently, as the chart below shows, but it’s less than convincing. In fact, it’s easy to think that the recent pop is just a pause in a broader decline.
But even taking the recent rise in the inflation outlook at face value, can we believe the Treasury market’s prediction? Is the uptick believable? Today’s Heard on the Street column in the Wall Street Journal raises some doubts:
…the Fed is buying regular Treasurys as it tries to prime the economy and keep inflation from slipping even further below its target range. But that risks distorting inflation-expectation signals from Treasury Inflation Protected Securities, or TIPS. Investors, and the Fed itself, compare yields on Treasurys and TIPS to get a read on what investors expect inflation to be five or 10 years out.
To compensate, the Fed is also buying TIPS and, as the Journal notes, is “attempting to compensate one distortion with another.” Is it working? Is the uptick in the inflation outlook credible? It’s not clear, which inspires looking elsewhere.
One reason for thinking that the higher inflation outlook is more than statistical noise comes via the latest reading on the annual percentage change in the money stock. The annual pace of the MZM measure, for example, has popped up recently, rising ever so slightly on a year-over-year basis through September 13, 2010, as the second chart below shows. That’s not much on its face, but it’s a notable change from the summer, when money stock for a time was falling by more than 2% on an annual basis.
Higher inflation expectations and an increase in the annual pace of the money stock looks fairly convincing. But is any of this having an impact on investor expectations about inflation as it relates to worries about low nominal yields? Not really, at least not yet. The benchmark 10-year Treasury yield was roughly 2.52% yesterday, up slightly from the day before and from 2.47% at the end of August. But that’s hardly an earthquake in market sentiment. In other words, not much has changed. We’ve had a few tremors, but the rumblings haven’t added up to much so far.
Something will change, of course, and perhaps soon, but deciding exactly what, and exactly when, isn’t getting any easier.