The president of the European Central Bank is worried about inflation. “We’re in an environment where we have a spike in the price of oil, commodities – it’s more acute in the present circumstances,” he says. Is the market also worried? Yes, at least on the margins.
aThe inflation forecast is creeping higher, based on the yield spread between the nominal and inflation-indexed 10-year Treasuries. As of yesterday, this market-based prediction of inflation was 2.51%, the highest since July 2008. By long-run historical standards, inflation in the 2.5% range is still quite low, although bond traders won’t fail to notice that the Treasury forecast has been climbing, albeit slowly, for several weeks.
“Investors are increasingly nervous that higher oil prices will push up headline inflation,” Nick Stamenkovic, a fixed-income strategist at RIA Capital Markets Ltd., tells Bloomberg. “The longer end [of the Treasury curve] is being influenced by the perceptions on inflation and creeping concerns that the Federal Reserve is getting a bit behind the curve compared to other central banks.”
Michael Pond, co-head of interest rate strategy at Barclays Capital, agrees that there’s a slight change in the trend these days. “Longer term the market has started to price in some inflation risk,” he explains via Reuters, “because there is concern about the effect of longer-term stimulative monetary policy, combined with growth in emerging markets, which are becoming an inflationary force.”
But it’s unclear if the tactical concerns of the moment will overwhelm what appears to be a solid strategic demand for Treasuries. Foreign investors continue to hold higher levels of U.S. debt. China, for instance, raised its stake in Treasuries by 39% as of December 2010 vs. a year earlier.
December numbers, of course, are suddenly stale, given the recent turmoil in the Mideast and the resulting pop in oil prices. Even if inflation isn’t a serious challenge at the moment, pricing pressures continue to threaten economies elsewhere around the globe. Standard & Poor’s today issued a warning about the “upward momentum” for inflation pressures in Asia.
Nonetheless, there’s still some debate about how much inflation threatens the mature economies. The IMF’s chief economist Oliver Blanchard, for one, thinks the risk is still minimal. For the U.S. and Europe, “oil prices and food prices don’t seem to have large inflationary effects,” he says.
Deciding if that view is informed, or something less, depends on whether the rise in commodity prices is a temporary phenomenon or the start of a new secular bull market. The case for thinking it’s the former may be frayed, but it’s still alive and kicking. CNNMoney reports that “a majority of investment strategists and money managers are leaving their year-end forecasts unchanged.” CNN continues: “On average, experts expect gold and oil prices to edge up about 4% by the end of 2011. That would put oil at around $95 a barrel and gold just under $1,500 an ounce by the end of the year. Crude prices started the year around $91 a barrel, while gold was at $1,420.”
General mayhem in the Mideast surely plays a role in driving oil and other commodities higher. To that extent, a return to relative calm could easily bring prices down. The real question is how much of the price hikes are related to stronger demand and a recovering global economy? Those factors represent more durable support for higher commodity prices, which in turn makes a stronger case for worrying about inflation.
The future, of course, is uncertain. Modeling political upheaval is about as reliable as herding cats. Even ECB President Trichet is reluctant to say for sure what comes next. Responding to a question about whether the latest advance in prices of raw materials was sustainable or fleeting, he advises: “We consider that we are in a universe that from that standpoint is uncertain.”