Tags: inflation

Flat Inflation? Don't Bet on It, says Bond Market

Saturday, 15 Mar 2008 07:18 PM

Consumers seemed to catch a break this month, if you buy the government’s official inflation report.

One widely followed market measure of inflation, however, paints a more disturbing picture.

Headline inflation -– which includes volatile energy and food costs -– in February remained at a comfortable 2.3 percent over the past 12 months.

Yet traders of Treasury inflation-protected securities, known as TIPS, appear to expect inflation to average 3.5 percent in coming years.

TIPS are regarded as an inflation hedge. The U.S. government makes regular interest payments to investors but at maturity returns an inflation-adjusted principal payment to the bond holder.

With the full backing of the US government and built-in inflation protection, the prices of TIPS are often used by economists to model inflation expectations. Lately, their models have been warning of much higher inflation ahead.

In recent weeks, TIPS market participants have been signaling increasing concerns about inflation. On some bond issues, the actual yields have even turned negative, meaning investors assume that after inflation, they will lose money by owning the bond.

Federal Reserve Governor Frederic Mishkin, in a recent speech, dismissed the significance of market prices. "My best guess is that much of the rise in inflation compensation reflects other factors,” he said.

Mishkin says that recent surveys of economists found only a small increase in expected inflation. But the surveys also reported an increase in uncertainty about inflation, which can lead to mispricing of securities.

Other economists are not so quick to presume that the market is so off-base.

"It is not clear that the [Fed] should be dismissive of the rise… A credible central bank should not only keep inflation expectations low and steady, but it should also prevent investors from pricing in substantial upside inflation risks,” says economist Brian Sack of Macroeconomic Advisers.

Economists at the Federal Reserve Bank of Cleveland seem to agree more with Sack than with Mishkin. Their model of inflation expectations factors in the degree of market uncertainty.

With this included, TIPS are pricing in the highest inflation seen in more than a decade.

"The bond market would appear to agree with the gold market that inflation has gotten dramatically worse in recent months. This in turn suggests that the explosive bull market [in gold] is being built on solid fundamentals,” concluded market watcher Mark Hulbert, after reviewing the data.

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Consumers seemed to catch a break this month, if you buy the government’s official inflation report.One widely followed market measure of inflation, however, paints a more disturbing picture.Headline inflation -– which includes volatile energy and food costs -– in February...
inflation
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2008-18-15
Saturday, 15 Mar 2008 07:18 PM
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