September 22, 2009
The Treasury market's inflation forecast has remained fairly steady since May, hovering in the 1.5% to 2.0% range. As of Monday's close, the current outlook for inflation is 1.80%, based on the yield spread between the nominal 10-year Treasury less its inflation-indexed counterpart.
As our chart below shows, this stability follows a period of extreme volatility, launched last September when the implosion of Lehman Brothers sparked a steep wave of selling in almost everything, government bonds being the leading exception.
The Treasury market's 1.8% inflation outlook contrasts with the most-recent 12-month change in the headline consumer price index, which dropped 1.5% for the year through August. But if we look at core CPI, which excludes the volatile energy and food sectors, prices rose by 1.4% for the 12 months through last month. That's just under the 1.8% inflation forecast implied by the Treasury market.
If future inflation for the next decade lives up to the current forecast, the pace of consumer price changes will compare well with the historical record. A world where inflation resides under 2% is favorable if we use the long-run past for comparison. But inflation expectations aren't a constant, which works well since inflation isn't set in stone either. And therein lies the potential for mischief making.
Such concerns will no doubt be on the agenda of the Fed's FOMC meeting, which begins today and concludes tomorrow. For the moment, however, the market expects that the central bank will keep monetary policy on an even keel, which is to say maintaining its Fed funds interest rate target of 0-0.25%.
As our second chart below illustrates, Fed funds futures project rates will stay unchanged for the next few months, rising slowly in 2010. If the futures market is correct, a year from now we'll see Fed funds at roughly 1.0%.
It all makes for a wonderful outlook. Inflation is low and expected to stay that way, save for a s-l-o-w rise in the months ahead from an extremely low base. As inflation projections go, this is about as good as it gets. And that's what worries us.
But for now, all's well. Enjoy it while it lasts.
Posted by jp at September 22, 2009 9:24 AM
Great question. The short answer: it depends. One problem is that the TIPS market hasn't been around long enough to make definitive conclusions. That said, the Treasury market's forecast has generally been pretty good in recent years before the turmoil of last year. Still, there's been a wide variety of forecasts from the Treasury market, depending on when you look and how you measure inflation and over what subsequent time period.
Of course, there's no reason to expect that market-based projections will always right at all times. Even the efficient market hypothesis doesn't promise that.
In any case, I'll try to take a deeper look at market history on this point in a future post.
Posted by: JP at September 22, 2009 10:50 AM
I just have to wonder what the range of views is that led to the Tr-TIPS spread.
My guess is that, in more normal times, the bid-to-cover ratio is pretty narrow for each of these measures (10Yr Treas & TIPS), but my guess is that the combination of inflationistas & deflationistas has made the spread much larger these days. Still, the average comes out to a "normal" 1.8% for inflation. (I wonder if there is a measure of that spread?)
The question is whether the deflationistas or the inflationistas will be right...or perhaps the middle-of-the-road types will prevail.
Posted by: Terry at September 22, 2009 10:39 AM
Does history give us any guide as to the predictive ability of the TIPS Spread? Do the bond boys tend to overshoot or undershoot predicting inflation?
Posted by: Brett Alexander at September 22, 2009 10:19 AM