Inflation (And Bernanke) Expectations

The market’s inflation outlook is holding steady again, but for how long? The implied inflation forecast, based on the yield spread between the nominal and inflation-indexed 10-year Treasuries, was 2.1% yesterday. That’s roughly where it’s been for the past week. It’s also down from 2.6% in early April. But we’re still a long way from the 1.5% at this time last year. What might be the next catalyst that moves the current inflation forecast — up or down? Fed Chairman Ben Bernanke’s speech later today is first on the list.

Meantime, the market’s inflation expectations are in a holding pattern, albeit at a relatively low altitude. A drop from current levels would surely be a dark sign, given the weak economy and the high levels of debt. The fall in the inflation outlook in recent months was a warning sign that macro conditions were deteriorating. This indicator also offered an early signal ahead of last year’s rough patch. Nonetheless, there’s fierce political opposition from Republicans for a new round of monetary stimulus. Will the GOP convince Bernanke not to respond to what appears to be rising money demand in the summer of 2011?

If the Treasury’s inflation forecast fades in the weeks ahead, the macro risks may be set to rise further. But not yet. How should the central bank react now? Economist James Hamilton earlier this week counseled:

…the more important and achievable goal for the Fed should be to keep the long-run inflation rate from falling below 2%. The reason I say this is an important goal is that I believe the lesson from the U.S. in the 1930s and Japan in the 1990s is that exceptionally low or negative inflation rates can make economic problems like the ones we’re currently experiencing significantly worse. By announcing QE3, the Fed would be sending a clear signal that it’s not going to tolerate deflation, and I expect that would be the primary mechanism by which it could have an effect. Perhaps we’d see the effort framed as part of a broader strategy of price level targeting.