Who’s Right About Inflation?

May 31, 2008 - When it comes to inflation, expectation is everything.  The two groups generally responsible for projecting their inflation expectations onto the U.S. economy are the professionals, the bond traders and the non-professionals, U.S. households, namely consumers.  Both of the aforementioned groups influences Fed policymaking decisions and the Fed’s job is doubly complicated when these two groups have divergent inflation expectations.  This in fact is the situation the Fed is currently facing as traders seem to be indicating low expectations of future inflation, as reflected by Treasury Inflation-Protected Securities (TIPS), the presumptive barometer of trader’s inflation expectations.  Consumers and traders have not been in sync regarding their inflation expectations in over two years when they collectively got it wrong and the rate of inflation was (thankfully) lower than expected.  TIPS, which were initially offered by the U.S. Treasury in 1997, pay interest to an investor several times a year and the principal rises with the rate of inflation (as measured by the consumer price index, AKA CPI) and declines in (rare) cases of deflation.  The interest paid on TIPS is generally lower than that of Treasuries and the difference between the two, referred to as the breakeven rate, is the rate of inflation anticipated by traders over the useful life of the securities.  However today, the expectation gap between the traders and the consumers has never been greater.   

TIPS are reflective of a commodities market which is on the brink of bursting as last month investors in TIPS experienced the biggest loss in several years.  Crude oil prices which have doubled in the past year, in conjunction with the rising prices of other commodities, are perceived as heading into bubble territory.  Consumers are seeing housing prices fall for the first time in decades while simultaneously experiencing skyrocketing fuel prices at the pump.  Those items closest to, and most frequently used by consumers, are surging in price while less frequently used items may be declining in price, in many cases to offset the direct impact of rising fuel prices on the consumer.  Unfortunately this time around though, it appears the consumer may have it right when it comes to accurately forecasting the inflation rate as they are taking the hit of higher prices directly in the wallet.   

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