SUSPICIOUS MINDS

Inflation fears are on the rise lately, courtesy of the upward momentum in the pace of the core consumer price index, which extracts food and energy from the mix. But judging by the market’s outlook on inflation, derived from inflation-indexed Treasuries (or TIPS, as they’re known), not much has changed this year. Mr. Market, it seems, isn’t worried about inflation. And perhaps that’s as it should be. The Fed tells us that a slowing economy will do the dirty work of cutting any inflation surprise off at the knee, and it’s becoming clearer that the economy is in fact slowing.
Nonetheless, core CPI advanced by 2.7% for the year through July–that’s up from 2.2% in 2005 and the fastest annual pace since 2001. A sign of things to come? Maybe, but the market-based outlook for inflation has been calm, cool and largely inert this year. Consider that at the close of 2005, the TIPS-based inflation projection (calculated by difference in yield between the nominal 10-year Treasury and the 10-year TIPS) was 2.33%, which inched up to just 2.53% as of yesterday, as our chart below illustrates.
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As warning signs of future inflation go, the one emanating from TIPS is a fairly tepid animal. Indeed, the current 2.53% forecast is well below both the latest reading on the annual change in core inflation (2.7%) and top-line inflation (4.1%).
Some may take comfort in the fact that the market thinks there’s no bull market in inflation, but a number of skeptics say that TIPS are less than a reliable forecasting mechanism when it comes to pricing trends. In fact, the subject of inflation and TIPS became a topical, if hotly debated subject yesterday after commentary from Arthur Laffer. Writing in The Wall Street Journal in a piece called “The Flawless Fed”, he invoked the securities and announced that a reading of the yield spread between nominal Treasuries and TIPS indicates that “over the past three years there has been no upswing in the market’s expectations of inflation.”
The blogosphere reacted, warning that reading the tea leaves from TIPS offers no special insight into the future, and perhaps a whole lot less than some assume. Bret Swanson at the Discovery Institute was speaking for some, including Don Luskin, when he wrote “Dr. Laffer says expected inflation gleaned from TIPS bonds is the best predictor of inflation, but in fact TIPS have not been very good at all at predicting inflation.” Macroblog weighed in as well, sparking a debate on Laffer’s assumptions.
For others, Laffer’s op-ed was swallowed hook, line and sinker. This blogger, for instance, cited Laffer’s commentary on low inflation expectations by way of TIPS to gush,

This spread tells you the market, which is the most efficient and effective entity when it comes to valuation and prediction, expects 10 year inflation rates around 2.5% a year, a very acceptable rate. This is just one more example that the US economy is in the best shape it has been for some time now. Mr. Laffer points out how good of a job managing monetary policy the Federal Reserve has done in a very difficult environment, and I would agreeā€¦.

Consensus is a rare commodity in the marketplace, and getting rarer by the day when it comes to economic assumptions. Even Mr. Market’s conclusions are increasingly suspect. All of which raises the question: why should we believe that 12 men and women voting in a room tucked away in Washington have any more insight into what the price of money should be than the collective judgment of the bond market? We’re always skeptical when people say, “The market’s wrong.” Of course, that’s true, albeit at selective points in time. But as a general proposition in the long run, one incurs more than a little risk when betting against Mr. Market.
At least J.P. Morgan was right when he famously advised that prices will continue to fluctuate. There’s one forecast we’ll take to the bank. Otherwise, it’s every man, women and bond trader for him- or herself.