Tuesday, November 18, 2008

Headline inflation down, core up

Today's inflation news—an unexpectedly large drop of 2.8% in October producer prices—was cheered by many as a sign that inflation pressures have vanished. The bond market figures that with collapsing energy prices and a weakened consumer, prices will actually fall substantially before this is over. That explains why the TIPS market today lowered its inflation expectations over the next 10 years to an all-time low of 0.7% per year. For the next 5 years, however, TIPS are priced to inflation averaging about -1% a year!

So according to the bond market, we were wallowing in inflation just a few months ago but now deflation is all but inevitable. I'm not so sure. As this chart shows, core inflation (taking out food and energy) has been rising steadily for the past two years. So the big source of the decline in "headline" or total inflation is simply falling energy and agricultural prices. If we were really headed for a general deflation, then core price inflation ought at least to be declining, but it's not.

The big difference between this recession and all previous recessions is that it wasn't produced by a tightening of monetary policy. Money has been plenty easy for the past several years, and the Fed today has pulled out all the liquidity stops. In every other recession we've had, inflation has fallen significantly not because the economy was weak, but because a shortage of money was the root cause of the weakness.

This adds up to reasons to hold off on celebrating the demise of inflation, and it suggests again that TIPS might be a worthwhile addition to your portfolio. Real yields are in very attractive territory because with deflation expectations rising, no one cares about TIPS' inflation protection. If inflation persists, however, TIPS will come roaring back into favor, and they will also deliver very attractive yields.

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