Inflation expectations still anchored

Headline inflation has turned higher since the start of the year amid a jump in food prices and sharply higher gasoline prices.

But it’s not just food and energy.  Commodity prices in general have surged on strong demand from China and emerging markets, while the Fed’s $600 billion in purchases of longer-term Treasuries, popularly known as QE2, also appears to be part of the problem (see QE, commodities and stocks).



An ultra-loose monetary policy, coupled with sharply higher raw material prices, has given way to talk among analysts and the public that much higher inflation is all but a certainty.

Anecdotal evidence from the Fed and a smattering of corporate earnings reports during Q1 do suggest that pricing power is beginning to emerge, and regional surveys of manufacturing by various regional Fed banks are detecting some movement in prices that manufacturers receive.

The University of Michigan’s survey of consumer sentiment, which includes inflation expectations, has detected upward movement in the public’s view of what will happen to inflation over the next year.

Further, core inflation has crept off the bottom.

But the longer-term inflation outlook – see chart, as measured by the ten-year break-even rate of inflation (the difference between the yield on the ten-year bond and ten-year TIPS, shows that inflation expectations remain reasonably anchored.

The reason it is called the break-even rate of inflation? The spread reveals what Treasury buyers are willing to give up in order to obtain a hedge against inflation.

Though not perfect, it does provide a rough look at the longer-term inflation outlook.

Expectations have moved higher since Bernanke first announced at the end of August that the Fed was considering a new round of bond buys. Notably, prior to Bernanke's announcement, inflation expectations has been cratering amid deflation chatter and growing worries about a double-dip recession.

But the spread is now near a five-year high.

Still, at just under 2.50%, investors have not lost confidence that the Fed can sop up the extra liquidity it has put into the financial system and prevent inflation from taking hold when growth eventually picks up. Plus, nascent worries about growth and mixed data have knocked off almost 20 basis points off the recent high.

And the relatively low level of inflation expectations is what gives the Fed the leeway to continue to hold rates at rock bottom levels and keep its primary focus on economic activity and job creation.