Saturday, September 19, 2009

TIPS Derived Expected Inflation: Only 1.75%

The top chart shows the weekly, bond market-based 10-year TIPS-derived expected inflation back to 2003, calculated as the difference between 10-year regular, nominal Treasury yields and 10-year Treasury inflation-indexed yields (measure of the real interest rate), both on a constant maturity basis (St. Louis Fed data here for 10-year TIPS and here for regular 10-year Treasuries); see the bottom chart for those yields graphed separately.

After an unusual period in late 2008 resulting in a narrowing spread when the TIPS 10-year yields were unusually high and approaching 3%, and regular Treasury yields were unusually low and approaching 2%, the Treasury market seems to have stabilized, and the bond market's 10-year expectation of inflation is now around 1.75%, lower than the inflationary expectations from 2003-2007 of around 2.5%.

Many analysts and economists seem to be worried about future inflation, resulting from the easy Fed monetary policy in 2008. Why doesn't the bond mark share those concerns? According to the inflationary expectations derived from the bond market, future inflation is less of concern now in 2009 than it was in 2007 before the increase in liquidity. What gives?


At 9/19/2009 2:45 PM, Blogger PeakTrader said...


Riding the yield curve
By Shaheen Pasha, staff writer
December 27, 2005

For those who see the yield curve as a crystal ball for the economy, the so-called inversion in the Treasury market Tuesday could be seen as a bad omen.

According to a 2003 analysis by the Federal Reserve Bank of San Francisco, each of the six recessions since 1970 was preceded by a yield curve inversion -- an unnerving precedence.

"The biggest risk in 2006 is that the Fed will be seduced by worries about inflation into raising rates too high," said Hugh Johnson, chairman of Johnson Illington Advisors. "A lot depends on what the 10-year does and while I would hope that they would take notice that it's going down in yield, the question is whether they will take it seriously or dismiss it."

The Fed has publicly discounted the usefulness of the yield curve as an economic indicator, saying that other factors, such as a heavy flow of overseas capital into the U.S., have driven the yield on 10-year notes to abnormally low levels -- distorting the yield curve's predictive abilities. (Bond prices and yields move in opposite directions.)

Fed Chairman Alan Greenspan earlier this year even called the persistence of low long-term Treasury yields despite rising short-term interest rates a "conundrum."

My comment:

U.S. supply and demand are at lower levels, and the bond market may be predicting slow real growth, despite the U.S. following Japan's quantitative easing policy (also, Japan's public debt to GDP ratio reached second in the world behind Zimbabwe in its Lost Decade). The bond market believes inflation expectations will remain low (the last Fed tightening cycle began in Jun '04).

At 9/19/2009 3:07 PM, Blogger bobble said...

"What gives?"

its called deflation.

the reserves supplied to banks by the fed are not being loaned out.

thus no increase in the money supply, thus no inflation.

instead,bank credit is contracting at a rapid rate , leading to *deflation*.

At 9/19/2009 3:47 PM, Blogger PeakTrader said...
US credit shrinks at Great Depression rate prompting fears of double-dip recession
By Ambrose Evans-Pritchard, International Business Editor
14 Sep 2009

Both bank credit and the M3 money supply in the United States have been contracting at rates comparable to the onset of the Great Depression since early summer, raising fears of a double-dip recession in 2010 and a slide into debt-deflation.

Professor Tim Congdon from International Monetary Research said US bank loans have fallen at an annual pace of almost 14pc in the three months to August (from $7,147bn to $6,886bn).

It is unclear why the US Federal Reserve has allowed this to occur.

Mr Congdon said a key reason for credit contraction is pressure on banks to raise their capital ratios. While this is well-advised in boom times, it makes matters worse in a downturn.

"The current drive to make banks less leveraged and safer is having the perverse consequence of destroying money balances," he said. "It strengthens the deflationary forces in the world economy. That increases the risks of a double-dip recession in 2010."

Referring to the debt-purge policy of US Treasury Secretary Andrew Mellon in the early 1930s, he added: "The pressure on banks to de-risk and to de-leverage is the modern version of liquidationism: it is potentially just as dangerous."

US banks are cutting lending by around 1pc a month. A similar process is occurring in the eurozone, where private sector credit has been contracting and M3 has been flat for almost a year.

Mr Congdon said IMF chief Dominique Strauss-Kahn is wrong to argue that the history of financial crises shows that "speedy recovery" depends on "cleansing banks' balance sheets of toxic assets". "The message of all financial crises is that policy-makers' priority must be to stop the quantity of money falling and, ideally, to get it rising again," he said.

He predicted that the Federal Reserve and other central banks will be forced to engage in outright monetisation of government debt by next year, whatever they say now.

Tim Congdon is an economist and businessman. He was a member of the Treasury Panel of Independent Forecasters (the so-called ‘wise men’) between 1992 and 1997, which advised the UK’s Chancellor of the Exchequer on economic policy. He founded Lombard Street Research, one of the City of London’s leading economic research and forecasting consultancies, in 1989, and was its Managing Director until 2001 and its Chief Economist from 2001 to 2005. He was an honorary professor at Cardiff Business School from 1990 to 2005 and is currently a visiting research fellow at the Financial Markets Group, the London School of Economics. His latest book Keynes, the Keynesians and Monetarism was published by Edward Elgar Ltd in September 2007. He was awarded the CBE in 1997 for services to economic debate. Tim Congdon was educated at Colchester Royal Grammar School and St. John’s College, Oxford, where he received a 1st Class degree in Modern History and Economics.

At 9/19/2009 9:10 PM, Anonymous Anonymous said...

Sounds like...oh, what's the word, stupidity, no,no, frigidity,no, oooh, I have it.

Liquidity trap.

At 9/19/2009 9:14 PM, Anonymous andy weintraub said...

The TIPS derived expected rate of inflation went from near zero in January 2009 to 1.75% in September. Extrapolating, that's about a 2.6% increase by the end of the year. Maybe it'll go up more? Maybe not? But with the money supply growing, and the need to borrow more to finance the rest of the "stimulus" package next year, it's hard not to bet on inflation. And the price of gold is leading the way.

At 9/21/2009 10:29 AM, Anonymous Anonymous said...

No velocity.


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