Is The Treasury Market’s Inflation Forecast Flashing A Warning?

The outlook for inflation is dropping fast, according to the yield spread between the nominal and inflation-indexed 10-year Treasuries. That’s worrisome if the economy’s growth momentum is slowing. Although some pundits argue that higher inflation is a big risk, the Treasury market is telling us different. If the economy is downshifting, falling inflation expectations are a sign of trouble.

The latest inflation forecast is 2.26%, based on yesterday’s yield spread for 10-year Treasuries. That represents a modest but consistent drop from just a month earlier, when the forecast was 2.6%. The decline is still moderate in absolute terms, which raises the possibility that it’s all just noise. But with some analysts warning that the economy may be headed for a rough patch, lower inflation expectations at this juncture aren’t productive.

“There’s a downturn in global industrial growth in clear sight,” predicts Lakshman Achuthan, managing director of the Economic Cycle Research Institute (ECRI). Given ECRI’s impressive record for calling major turning points in the business cycle, Achuthan’s warning isn’t easily dismissed.
Looking on the bright side, the latest broad profile of the U.S. economy still suggests growth has the upper hand. The Chicago Fed National Activity Index (a a weighted average of 85 Indicators) rose in March. That was “the fourth consecutive positive reading of the index and the sixth consecutive positive contribution from employment-related indicators. Neither has exhibited such patterns since April 2006,” the Chicago Fed reports.
But March is suddenly ancient history. More recent economic news is mixed. For example, the pace of growth for the ISM Manufacturing Index for April slowed, as did the ISM services industry index. Then again, April’s private nonfarm payrolls increased by the most since the recession ended, although the recent rise in new jobless claims has raised new questions about the labor market’s resiliency.
Meantime, an early reading on economic activity for this month paints a cautious picture. Business activity in the Philadelphia region continued to rise in May, but the gain was the weakest in eight months, the Philadelphia Fed reports.
ECRI’s prediction notwithstanding, it’s too early to throw in the towel on growth. Indeed, last month’s rise in payrolls suggests there’s still a fair amount of forward momentum in the economy. Still, it would be foolish to ignore the warning signs. Much depends on the trend implied in the incoming round of economic reports. Next week, for instance, brings fresh numbers on durable goods orders, initial jobless claims, and personal income and spending.
Meantime, let’s keep an eye on the Treasury market’s inflation forecast. If this prediction continues to drop, it’s sure to cast a dark shadow over the macro view. Ironically (or tragically), a similar warning started bubbling about this time last year, as we noted at the time (here and here, for instance). The falling inflation forecast was an early sign of trouble in the spring of 2010. It’s premature to argue that a repeat performance is fate, but it’s also too early to dismiss the possibility.