Inflation Expectations Continue to Heat Up

by: Calafia Beach Pundit April 08, 2011

As a follow up to a recent post about how the bond market is worrying about inflation, I post these charts. The top chart shows the relationship between 5-yr TIPS and 5-yr Treasuries, with the spread between their real yields (which equates to the market's expectation for the what the CPI will average over the next five years) now within a few bps of an all-time high (2.85%). The second chart does the same for 10-yr maturities, and the spread there has now reached 2.63%, which is also very close to its highest level since 2005.

The message of both charts is the same: Inflation expectations are rising significantly. Fed supporters would be quick to note that this could just be a rational reaction to the recent and continuing rise in oil prices. But Fed critics have more ammunition: The very weak dollar, the broad-based rise in commodity prices, the all-time highs in precious metals, and the substantial rise observed to date in the producer price indices and the ISM prices paid indices.

There is no shortage of evidence that monetary policy is extremely accommodative and inflation pressures are building. The last refuge of the inflation doves (the Phillips Curve theory of inflation) is being dismantled almost daily, as prices all over the world rise even as there remains plenty of slack in the U.S. economy.

To his credit, Dallas Fed President Richard Fisher today sounded a pretty strident inflation alarm: "Inflationary impulses are gaining ground in the rest of the world ... this will result in some unpleasant general price inflation numbers in the next few reporting periods ... there is the risk that we might breach our duty to hold inflation at bay."

I think it is now clear that the Fed has way overstayed its welcome with QE2, and I find it hard to believe that the rest of the Fed governors will ignore the mounting evidence of such. The ECB has already made the first move to tighten, and meanwhile the figurative rats are abandoning the sinking U.S. dollar (see my prior post on Brazil).

QE2 is scheduled to finish in a few months, but if it is abandoned now it will hardly be cause for concern, since the remaining Treasuries to be bought represent only a very tiny fraction of the total outstanding, and thus are very unlikely to make much of a difference to yields and/or the economy. What will make a difference, of course, is a Fed decision to ignore the evidence of rising inflationary pressures.

My comments:

In the last bull cycle, the Fed started hiking rates in June 2004. 5 year inflation expectation was at 2.6%. Now, inflation expectation is at 2.9%. The Fed should have started hiking late 2010. The 10-year UST is around 3.4%. This means that from 0.25% to 3.4%, there are about 13 hikes to go before the yield curve inverts. From Nov 2010 till Dec 2011, that's 13 months of supposed hiking.

The Fed is "way behind the curve". They are 5 months late in their hiking and counting. It will be very difficult for them to control inflation if they hike in 2012. Back in 2004, Alan Greenspan was criticised for acting on inflation too late. This time, Bernanke's far worse.

If the yield curve were to invert in Dec 2011, expect a recession in 2013. The stock market could enter into a bear cycle as late as mid 2012. We have about slightly over a year left in this bull.