Inflation Worries?

Tim Duy is worried about inflation:

Note also that gold broke out above $700, copper bounced today, oil is poised to make a run for $80, the Baltic Dry Index is off the charts, productivity growth is falling, and the Dollar is set to make another drop. Moreover, I suspect China will be revisiting their currency/foreign exchange reserve policies after the 2008 Olympics, adding to additional downward pressure on the Dollar.

In short, I think the Fed is rightfully cautious about the inflation outlook, but policymakers are likely to cut rates anyway. Historians should take note; I have a sick feeling that this is the moment the tide turned on the 25+ year battle against inflation.

Considering Professor Duy’s apparently high inflation expectations and my low expectations (see point 3 from yesterday), this might be a good occasion for a wager. Unfortunately, pseudonymous persona that I am, I don’t think I’m permitted to make wagers. But if Professor Duy is a betting man, he can get plenty of action from my friend Mr. Market. I see the 10-year T-note quoted at a yield of 4.31%, while the 10-year TIPS is quoted at 2.12% -- a spread of 2.19%, even slightly narrower than the 2.20% where it closed at the end of August. I’ve been keeping track of the month-end closes of this spread, and August 2007 was the narrowest close since October 2003. So if anyone wants to bet on higher inflation, Mr. Market is offering rather attractive terms.

Realistically, one has to recognize that the TIPS-to-nominals spread is narrow in part because of a liquidity premium in the TIPS yield, given today’s thirsty market conditions. So I’m not entitled to say with confidence that the bond market anticipates a CPI inflation rate of 2.19% over the next 10 years or that its anticipated inflation rate is lower than it has been since 2003. Nonetheless, since the yield on nominal T-notes should include a premium for purchasing power risk, and since, by now, TIPS are not all that much less liquid than nominal T-notes, I think it’s fair to say that the bond market doesn’t share Professor Duy’s sick feeling.