The Great Inflation Debate

by: James Picerno August 20, 2008 | about stocks: DIA / QQQQ / SPY    
James Picerno

James Picerno

About this author:
Become a Contributor Submit an Article
  • Font Size:
  • Print

What's the outlook for inflation?

The question is simple enough. But the answer is complicated these days. In fact, there's an array of inflation expectations to pick from in the summer of 2008. If you're looking to commodity prices as an early warning sign of future pricing trends, the message has been clear: inflation will rise in the months and years ahead.

Skeptical? Perhaps the recent updates on consumer and wholesale price inflation will change your mind. As we noted yesterday, the trend in producer prices has been unmistakably up. Meanwhile, consumer price inflation shows similar symptoms.

Expecting inflation to continue bubbling, in other words, seems like a reasonable proposition. Or so recent history suggests. But such thinking finds no favor in the Treasury market. The prospect of higher inflation is a bond investor's worst nightmare, but you'd never know it by looking at the CPI-adjusted yield on the nominal 10-year Treasury. Buyers of the 10 year apparently have no fear of buying a fixed-rate bond at a yield that, after adjusting for consumer price inflation for the past year, looks somewhat unappetizing.

As our chart below shows, the 10-year Treasury yield less annualized consumer price inflation has been sinking into negative territory for some time. As of July, the 10-year Treasury's CPI-adjusted yield was negative 1.59%, based on using the monthly 10-Year Treasury constant maturity yield and subtracting the 12-month change in CPI, with data courtesy of the St. Louis Fed.

Suffice to say, it's been a while since the 10-year offered so little inflation-adjusted yield compensation. Not since the early 1980s has the prospect of owning a government bond looked so grim as an income producing security once inflation is considered. We can debate what it means, and whether it's even relevant for assessing the future of inflation. Nonetheless, the graph above is worth a close look before one dives headfirst into Treasuries at this point.

Or is it? The inflation-indexed Treasury market, a.k.a., the TIPS market tells us that the outlook for inflation is hardly frightening. As the second chart below suggests, the TIPS market is predicting consumer price inflation will run at less than 2.2%, or far below the 5.6% annual pace of CPI reported for July. (The TIPS inflation forecast is calculated as the spread between the nominal 10-year Treasury and its inflation-indexed counterpart.) This is the lowest inflation outlook in years from the TIPS market.

Clearly, something's amiss in the world of inflation forecasting. Maybe. Deciding where the error lies in real time is a challenge, of course. But that doesn't keep us from guessing. For our money, we doubt that headline consumer prices over the next 10 years will stay tame in the low-2% range. Call us crazy, but expecting something higher looks prudent.

Obviously, not everyone agrees. The glitch is that some believe the risk of recession, deflation and general turmoil in the economy overall will keep pricing pressures low in the years ahead. Investors have run for cover on the assumption that more trouble lies ahead, and the cover includes buying Treasuries, in both nominal and inflation-indexed forms. The higher demand has, of course, pushed yields down. And with the world more inclined to worry about deflation/disinflation, fear of inflation has been virtually dismissed. For the moment, anyway.

Alas, we don't know which forecast is right, but we do know that betting the farm on 2% consumer price inflation through 2018 doesn't look all that attractive as an investment proposition. Even in a world where credit crunches and debt reduction looks likely, one has to expect an especially dire scenario to think that inflation will all but evaporate in the years ahead. Yes, anything's possible, but not everything's probable.

Related Articles

This article has 7 comments:

  •  
    Aug 20 01:36 PM
    Inflation or deflation? It's not an either/or question (nod to Kierkegaard). We have both, simultaneously, in different areas, commodities, asset classes, etc. Once the investor sorts out which is which, positioning one's portfolio does not require a PhD in quant analysis. A steady application of what a former colleague, The Redneck CPA, terms "walking around sense," goes a long way in times like these.
    Reply | Link to Comment
  •  
    Aug 20 02:03 PM
    I would like to point out what a no-brainer it is to buy some 10 year tips (if you can get them trading below par, otherwise you do take some defllation risks).

    Since 1970, there have only been 5 years where inflation was below 2%. There has never ever been a year with deflation. A ten year tip trading at 97 guarantees you at least 1.5% return in the most deflationary environment possible vs much larger returns if there is normal or excess inflation.
    Reply | Link to Comment
  •  
    Aug 20 02:46 PM
    This is a foolish debate... TIPs are not "inflation" securities, they are CPI securities. Go look at the BLS website, where they explicitly say that CPI is a price index, not an inflation index. TIP yields are nothing more than Treasury yields minus expected **CPI**, which is not the same thing as inflation.

    As for low Treasury yields, this reflects investor fear. With accounting fraud running rampant, a probable recession, and a general lack of leadership in Washington (both parties) -- investors are more worried about a return **OF** principal, rather than a return **ON** principal. Everyone knows Treasuries yields are "too low", but they also know that any positive yield (however small) is much better than a negative yield.
    Reply | Link to Comment
  •  
    Aug 20 04:24 PM
    actually tips are such a bargain for the Treasury due to fear. Simple fear that no one is driving the bus and it will go off the road, so the man with the press is the man to love. I do love Hank the old stinker, he has the markets so confused that nary a soul will be able to figure it out. But Treasuries are not income paper, just a return of capital offer. I think that is good all things considered. Z
    Reply | Link to Comment
  •  
    Aug 20 07:15 PM
    Ok, gramps. I agree with you & bill gross that inflation and CPI are not the same. Regardles, just look at the 30+ years of CPI data, make your best guess what the next 10 years will look like... and tell me that TIPs are not a better deal than conventional treasuries.
    Reply | Link to Comment
  •  
    Aug 21 01:49 PM
    I am investing in printing presses and paper, seems a safe bet to me.
    Reply | Link to Comment
  •  
    Aug 22 07:04 AM
    Looks to me like inflation will not change much. We are in time of disinflation --housing down, commodities down, autos down. computers down. The final spear in the heart of inflation is wages are not up.
    Reply | Link to Comment
More Comments on DIA ยป
Top Rated Comment Streams:

Numbers are net rating-

See all Top 100 »
More by James Picerno

Investment Resources
Money Management
Research
Seeking Alpha provides these ads as a service to its leading contributors
Articles on related themes
Market Outlook
Economy
Bonds
Dollar/Currencies